Auditor Independence, Audit Committee Effectiveness, and Earnings Management

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AUDITOR INDEPENDENCE, AUDIT COM M ITTEE EFFECTIVENESS,

AND EARNINGS MANAGEMENT
by
Nicole Thome Jenkins
A thesis submitted in partial fulfillment

of the requirements for the Doctor of
Philosophy degree in Business Administration
in the Graduate College o f
The University of Iowa
December 2002
Thesis Supervisors: Professor Daniel W. Collins
Professor Morton K. Pincus
Reproduced with permission o f the copyright owner. Further reproduction prohibited without permission.
UMI Number: 3073378
Copyright 2002 by
Jenkins, Nicole Thome
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2002
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Graduate College
The University of Iowa
Iowa City, Iowa
CERTIFICATE OF APPROVAL
PH.D. THESIS
This is to certify that the Ph.D. thesis of

Nicole Thome Jenkins
has been approved by the Examining Committee
for the thesis requirement for the Doctor of Philosophy
degree in Business Administration at the December 2002 graduation.
Thesis C om im ^^T^ ' ^ ^ ^ ^ ^
U
Q U L l
Daniel W. Collins, Thesis Supervisor
c
Morton K. Pincus, Thesis Supervisor
W. Bruce J
George K . Neumann
QiA^JjjAlJLL
Richard M. Tubbs"-""
To Toby, the spice in my life,

and Marilyn and Elijah Thome, my parents,
without whom there would have been no me.
ii
My son, do not forget my teaching, but keep my commands in your heart, for they will
prolong your life many years and bring you prosperity. Let love and faithfulness never
leave you; bind them around your neck, write them on the tablet o f your heart. Trust in
the Lord with all your heart and lean not on your own understanding; in all your ways
acknowledge him, and he will make your paths straight.
Proverbs 3:1-6
iii
ACKNOWLEDGMENTS
I wish to express my sincerest appreciation to Professors Daniel W. Collins and

Morton P. Pincus, my co-chairs, for their invaluable guidance and assistance during the
completion of the project. I would also like to thank Professors W. Bruce Johnson,
George R. Neumann, and Richard M. Tubbs for their helpful comments, feedback, and
support in the writing o f this paper. This document has also benefited from the
comments of Michael Cipriano, S. Paul Hribar, William C. Schwartz Jr., Scott
Vandervelde, and workshop participants at Emory University, University o f Iowa,
Michigan State University, Washington University in St. Louis, and Yale University.
I am grateful to the KPMG Foundation via the Ph.D. Project, the American
Accounting Association, and the University o f Iowa Accounting Department and
Graduate College for their financial support that allowed me to focus a significant
amount of my time on research while studying at the University o f Iowa.
Bemie Milano, trustee of the KPMG Foundation, dreamt a dream and through
extraordinary faith and perseverance is watching it come true in living color. To those
whose friendship has always been a blessing to me, Astrid Caron, Lisa M. Damge, Bryce
and Laura Beane Freeman, and Cynthia Tollerson. To my parents and family, I will be
forever grateful for the sacrifices they have been made to ensure my success in this
program and in life. Finally, and most important o f all, I would like to thank my husband
Toby for his blind faith and unwavering support. In all things, God saw my need and met
it time and time again. Amen! Amen! Amen!
ABSTRACT
I examine the joint association between earnings management and two monitoring
mechanismsaudit committee effectiveness and auditor independence. Because of
concerns regarding the lack of oversight by audit committees and the effect o f non-audit
services on the quality of financial reporting, the Securities and Exchange Commission
(SEC) initiated audit committee regulations and revised auditor independence rules.
Using data collected from the 2001 proxy statements o f a sample o f Fortune 1000 firms,
I present evidence that effective audit committees and independent auditors jointly
diminish earnings management. I find that effective audit committees and more
independent auditors both mitigate income-increasing earnings management, and they
both appear to induce a conservative bias on income-decreasing earnings management.
These results are contrary to those found in prior studies which indicate that both
monitoring mechanisms drive earnings management toward zero in both the incomeincreasing and income-decreasing sides o f the distribution. My findings have
implications for future research of how various monitoring mechanisms mitigate earnings
management. Specifically, my work suggests that future research should consider not
only the magnitude but also the direction of performance adjusted abnormal accruals as a
surrogate for earnings management. Moreover, when investigating the role o f audit
committees and external auditors in financial reporting issues, both monitoring
mechanisms must be considered jointly. Lastly, the innovations o f the SEC with regard
to audit committees and auditor independence has positively affected the quality of
financial reporting. However, my results indicate that additional improvement may be
obtained through standardization of regulations and enforcement.
TABLE OF CONTENTS
LIST OF TABLES................................................................................................................ vii

CHAPTER 1. INTRODUCTION...................................................................................... 1
CHAPTER 2. BACKGROUND AND HYPOTHESIS DEVELOPMENT....................6
2.1 Prior Auditor Independence Research............................................ 9
2.2 Prior Audit Committee Research................................................... 11
2.3 Are Earnings Management Monitoring Mechanisms
Related?........................................................................................13
2.4 Proxy for Earnings Management...................................................16
2.5 Income-Increasing and Income-Decreasing Abnormal
Accruals........................................................................................16
CHAPTER 3. RESEARCH DESIGN................................................................................21
3.1 Empirical Model............................................................................ 21
3.1.1 Control Variables..............................................................24
3.2 Non-nested Technique................................................................... 26
3.3 Non-symmetric Model................................................................... 26
CHAPTER 4. SAMPLE, EMPIRICAL RESULTS, AND ADDITIONAL
ANALYSES....................................................................................29
4.1 Descriptive Statistics....................................................................29
4.2 Absolute Value Versus Signed Abnormal Accrual
Models......................................................................................... 33
4.3 Are Auditor Independence and Audit Committee
Related with Respect to Mitigating Earnings
Management?.............................................................................. 33
4.4 Non-symmetric Model................................................................... 37
CHAPTER 5. SENSITIVITY ANALYSES..................................................................... 40
5.1 Incentives Versus Control Variables.......................................... 40
5.2 Controlling for Firm Performance................................................41
5.3 Incentives to Manage Earnings..................................................... 43
5.4 Follow-up Work............................................................................ 46
CHAPTER 6. CONCLUSION AND SUMMARY OF FINDINGS...............................47
APPENDIX A. ESTIMATION OF AUDIT COMMITTEE EFFECTIVENESS
USING PRINCIPAL COMPONENTS......................................... 51
APPENDIX B. NON-NESTED MODEL......................................................................... 54
APPENDIX C. NON-SYMMETRIC CENSORED MODEL......................................... 57
APPENDIX D. TABLES................................................................................................... 59
REFERENCE.......................................................................................................................77
vi
LIST OF TABLES
Table D l. Sample Selection Procedure..............................................................................59

Table D2. Sample Descriptive Statistics.............................................................................60
Table D3. Correlation M atrix............................................................................................. 64
Table D4. Absolute Value o f Abnormal Accruals M odel................................................ 67
Table D5. Signed Value o f Abnormal Accruals Model.....................................................69
Table D6. Non-symmetric Censored Model........................................................................71
Table D7. Non-symmetric Censored Model - Adjusted for Firm Performance.............. 72
Table D8. Benchmark Beaters - Earnings Greater than Z ero ..........................................73
Table D9. Benchmark Beaters - Earnings Greater than Prior PeriodEarnings...............75
v ii
1
CHAPTER 1. INTRODUCTION
Several recent high profile cases of accounting irregularities, which have led to
billions of dollars o f market value losses, have prompted regulators to take actions to
address perceived audit failures. I The Securities and Exchange Commission (SEC)
updated the auditor independence rules and spearheaded efforts to have major stock
exchanges implement regulations aimed at improving the effectiveness o f audit
committees. These actions were taken because the SEC and other advisory committees
(e.g., Canterbury Commission, Treadway Commission, OMalley Panel, and the
Independence Standards Board) appear to believe that increased auditor independence
and enhanced audit committee effectiveness will lead to lower earnings management and,
hence, higher quality financial reporting. Whether this is in fact the case remains an open
issue.
This study examines the combined effects o f audit committee effectiveness and
auditor independence on earnings management. Prior studies by Klein (2002), Peasnell,
Pope, and Young (2000), Chtourou, Bedard, and Courteau (2001), Frankel, Johnson, and
Nelson (2001), and Ashbaugh, LaFond, and Mayhew (2002) have implicitly assumed that
these monitoring mechanisms act independently from one another. These studies have
examined the effects o f one o f these monitoring mechanisms on earnings management
while ignoring the effect of the other. However, there is no evidence that these
1 Examples of companies that overstated earnings includeCendant, $500 million (CFO

Magazine 1998); Sunbeam $71 million (Business Week 1998); McKesson HBOC Inc. $42.2
million (CNNfn 1999); Informix $244 million (CNNfh 2000); MicroStrategy $66 million
(BusniessWeek 2000); Rite Aid $1 billion (Washington Post 2001); Waste Management $1.4
billion (Washington Post 2001); Enron $1 billion (BusinessWeek 2002); and WorldCom $9.0
billion (Joyce 2002).
2
monitoring mechanisms operate independently of one another to deter earnings
management. Indeed, because audit committees are charged with oversight
responsibilities with respect to external auditors, there is likely a relation between these
two monitoring mechanisms. Therefore, prior work that examines the impact o f audit
committee effectiveness or auditor independence on earnings management in isolation
may have overlooked an important factor. Moreover, the prior analyses may be subject
to possible specification error and potential bias that cloud the interpretation of the
results. To better understand these two monitoring mechanisms and their effects on the
quality of financial reporting, I investigate the joint effects o f audit committee
effectiveness and auditor independence on earnings management. In particular, I allow
the data to reveal if more or less earnings management is mitigated when both of the
monitoring mechanisms are operating at a high level in firms.
Prior studies have investigated the relation between earnings management and
auditor independence or audit committee effectiveness by examining the magnitude of
the absolute value o f abnormal accruals as a proxy for earnings management (Frankel, et
al. 2001; Klein 2002). The use o f the absolute value of abnormal accruals to capture
earnings management implicitly assumes that the relation between the monitoring
mechanisms and earnings management is the same regardless of the direction o f earnings
management. That is, the absolute value model assumes that the monitoring mechanisms
are equally effective in deterring income-increasing and income-decreasing earnings
management. Academic research often regards income-increasing and incomedecreasing earnings management as being equally detrimental to the quality o f earnings.
However, it is not clear that auditor independence and audit committee effectiveness act
as equally effective deterrents to income-increasing and income-decreasing earnings
management. Concern about minimizing litigation risk resulting from earnings (asset)
overstatements may prompt external auditors to adopt a conservative bias that will lead to
smaller income-increasing accruals, but larger (i.e., more negative) income-decreasing
3
accruals. Similarly, members o f the audit committee are concerned about minimizing
their financial liability and shielding their reputation from the effects o f overstatements
(Abbott and Parker 2000). Using the absolute value model of abnormal accruals as a
proxy for earnings management could cause these effects to be overlooked. In this paper,
I initially use a non-nested regression technique to evaluate the ability o f the monitoring
mechanisms to explain differences in both the magnitude and direction (i.e., signed
abnormal accruals) o f earnings management. This technique allows me to examine
whether the absolute value model is well specified and superior to a signed abnormal
accrual model.
Whether audit committee effectiveness and auditor independence are equally
effective in deterring income-increasing versus income-decreasing earnings management
is an open issue, which I address via a signed abnormal accrual model. I estimate a nonsymmetric censored model that allows the relation between the monitoring mechanisms
and earnings management to vary according to whether abnormal accruals are incomeincreasing or income-decreasing. In addition, my model allows for interaction effects
across the two monitoring mechanisms.
Results from my extension of prior work, support the SECs notion that both audit
committee effectiveness and auditor independence influence the level o f earnings
management by inducing a conservative bias. Moreover, these results demonstrate that
the monitoring mechanisms are not independent from one another as assumed in prior
research; rather, they appear to act as substitutes. In addition, the results show that future
analyses o f the monitoring mechanisms should consider both mechanisms and their
interaction to ensure proper model specification and interpretation o f results.
By considering signed abnormal accruals as a proxy for earnings management and
estimating a non-symmetric model, I document that the direction o f earnings
management matters when considering the effectiveness o f alternative monitoring
mechanisms. When using a performance adjusted proxy for earnings management, I find
results consistent with my initial hypotheses that both audit committee effectiveness and
auditor independence induce a conservative bias on the abnormal accruals o f firms. I
find that more effective audit committees and more independent external auditors are
both associated with smaller income-decreasing (more negative) and income-increasing
(closer to zero) earnings management. It appears that the threat o f litigation and possible
reputation effects are strong motivators for both audit committees and external auditors.
When the proxy for earnings management is not adjusted for firm performance the results
with respect to independent auditors effecting income-increasing earnings management is
not significant.
Similar to prior work, I investigate the robustness of my findings for firms that
just beat specific earnings benchmarks. I compare the sub sample o f firms that just beat
the benchmark to the sub sample of firms that just miss the benchmark. I identify the
direction of earnings management within each sub sample by measuring earnings
management with signed abnormal accruals. Effective audit committees appear to play a
more significant role in mitigating earnings management for firms that just miss relative
to firms that just beat zero earnings. Auditor independence was not significantly different
between the two sub samples.
Future studies of earnings management should therefore consider signed
abnormal accruals in addition to the absolute value o f abnormal accruals adjusted for firm
performance as earnings management proxies. These alternative specifications will
enable researchers to disentangle the different effects that the magnitude and direction o f
earnings management have on the relation between earnings management and variables
o f interest. Moreover, researchers using earnings benchmarks may consider comparing
just beat firms to just miss firms that are similarly motivated to manage earnings to beat
the benchmark.
The next chapter provides an overview o f audit committee effectiveness, the
auditor independence rule, related research findings, and development o f the hypotheses.
Chapter m describes the research design. Chapter IV presents the empirical results, while
sensitivity analyses and follow-up work are discussed in Chapter V. I present a summary
of findings and conclusions in Chapter VI.
6
CHA PTER 2. BACKGROUND AND HYPOTHESIS
DEVELOPMENT
The SEC defines inappropriate earnings management as the use o f the flexibility
in GAAP to distort the underlying financial performance o f a company (SEC 2001 and
Levitt 1998). While academic research appears to draw a distinction between good and
bad earnings management (Healy and Wahlen 1999), the SEC does not seem to make
this delineation. Rather, the SEC appears to view any distortion o f earnings as
inappropriate earnings management. Because I am providing evidence about the
effectiveness o f a SEC policy, I adopt their definition of earnings management. I also
adopt this approach because, to date, there is not a reliable empirical method to
distinguish good earnings management that is aimed at making economic performance
more transparent from opportunistic (bad) earnings management that seeks to conceal
underlying economic performance.
The SEC has updated the auditor independence rule and led the way in the
implementation o f regulations to improve audit committee effectiveness. The SECs
discussions surrounding these actions imply that they believe that improving these
monitoring mechanisms will mitigate earnings management and improve the quality of
financial reporting (SEC 2001). Both o f these monitoring mechanisms are part of a
firms overall corporate governance structure.^ There are other components o f firms
corporate governance structure that have been examined in prior literature (e.g., board o f
directors characteristics, other board committees, compensation contracts, etc.). In this
paper, I examine external auditor independence and audit committee effectiveness
2 The corporate governance structure is the system of mechanisms in place within a firm to
monitor the behavior of managers and ensure that the interests of shareholders are being
protected.
7
because these are the two monitoring mechanisms that the SEC has specifically identified
as being most important and effective in mitigating earnings management. Former SEC
chairman Arthur Levitt noted the importance o f these two monitoring mechanisms in the
following terms:
We will devote significant resources in the coming year to the promotion o f high
quality accounting standards and transparency by focusing on inappropriate
earnings management, auditor independence, and the role o f audit committees.^
Enrons recent announcement to restate prior years earnings and its subsequent
bankruptcy filing prompted current SEC Chairman Harvey L. Pitt to identify several
enforcement actions. Chairman Pitt cited improvement in the self-regulation of auditors,
including monitoring adherence to professional and ethical standards, and enhanced audit
committee effectiveness as two responses that will improve the transparency and
credibility o f financial reporting (Pitt 2001; BusinessWeek 2001). It is clear that the SEC
believes that auditor independence and audit committee effectiveness are two very
important mechanisms for addressing the perceived erosion o f earnings quality.^
The Blue Ribbon Commission on Improving the Effectiveness o f Audit
Committees (BRC) was formed in September 1998 in response to then SEC Chairman
Arthur Levitts concern about the adequacy o f corporate directors oversight o f the audit
process. Sponsored by the SEC, the New York Stock Exchange (NYSE), and the
3 Testimony Concerning Appropriations for Fiscal Year 2000 (Levitt 1999 p.6).
4 Since the collection of my sample and my subsequent analysis, Congress has adopted SarbanesOxley Act o f2002 which requires CEOs and CFOs to prepare a written statement to accompany
the audit report certifying the "appropriateness of the financial statements and disclosures
contained in the periodic report, and that those financial statements and disclosures fairly present,
in all material respects, the operations and financial condition of the issuer." However, the SEC
did not decrease die burden they placed on auditors and audit committees; therefore, the findings
of this analysis continue to be of interest following the enactment of Sarbanes-Oxtey in 2002.
8
National Association o f Securities Dealers (NASD), the BRC was charged with making
recommendations on strengthening the role of audit committees in overseeing the
corporate financial reporting process.^ The BRC issued its report in February 1999
detailing several recommendations for improving audit committee effectiveness. The
BRC included recommendations on the size and composition o f the audit committee and
on the financial background of audit committee members.^ Following this report, the
NYSE, NASDAQ, and the American Stock Exchange each adopted some aspects of the
BRCs recommendations.
On November 15, 2000, the SEC adopted the Final Rule: Revision o f the
Commissions Auditor Independence Requirement (i.e., the auditor independence rule) to
strengthen and clarify the criterion to ensure that external auditors act independently of
their clients. The rule is comprised of three restrictive requirements for audit firms and
one disclosure requirement for registrants. It restricts specific financial and employment
relationships between auditors and clients, restricts certain non-audit services that
auditors can provide to clients, and provides specific guidelines for the quality control
procedures o f audit firms 7 The auditor independence rule also requires registrants to
5 Press Release 98-96 SEC September 28,1998 p.l.

6 The BRC also recommended the adoption of a written audit committee charter. The annual
proxy statement is to include the charter, a statement about the audit committees compliance
with its charter, and a discussion of the responsibilities and functions of the audit committee and
the outside auditor.
7 The auditor independence act deemed nine services that by regulation impair the auditors
independence. These include: bookkeeping or other services related to the audit clients
accounting records or financial statements, financial information systems design and
implementation, appraisal or valuation services and fairness opinions, actuarial services, internal
audit services, management functions, human resources, broker dealer services, and legal
services. All other non-audit services including tax services are referred to as other non-audit
services. Sarbanes-Oxley Act 2002 restricts external auditors from performing these services and
it also restricts auditors from performing any other service that the Board determines, by
regulation, to be impermissible. This addition was available to the Board prior to the passage of
the act; however, it is explicitly stated and emphatically encouraged since the Acts adoption.
9
disclose in their proxy statements the fees paid to their external auditor for audit services,
financial information systems design and implementation work, and all other non-audit
services. 8
2.1 Prior Auditor Independence Research
The SEC appears to believe that auditor independence is impaired when the
auditor performs significant non-audit services for clients. Moreover, the SEC rules on
auditor independence strongly suggest that the more independent the external auditor, the
higher the quality of the audit performed, resulting in a lower level of earnings
management. Frankel, Johnson, and Nelson (2001) test this hypothesis using a sample of
firms from the 2001 proxy season. They use the ratio o f non-audit fees to total fees paid
by the firm to its external auditor as a proxy for the degree to which auditor independence
may be impaired. Frankel, et al. (2001) find that firms with a higher proportion of non
audit fees appear to manage earnings to a greater degree, as compared with firms that
have a lower proportion o f non-audit fees.9 These findings seem to support the SECs
concern regarding auditor independence and suggest that firms with more independent
auditors have higher quality earnings (i.e., less earnings management). In a follow up
8 The disclosure rule also requires the audit committee, or board of directors if there is no audit
committee, to consider and report on whether the non-audit services provided have allowed the
principal accountant to maintain its independence. A final disclosure requirement relates to the
use of part-time/temporary staff by several non-Big 5 accounting firms in conducting an audit.
Registrants are required to disclose the percentage of hours spent by persons other than the
audits permanent staff in performing the audit.
9 Frankel et al. examine two proxies for earnings management. First, they use the absolute value
of abnormal accruals as estimated by the cross-sectional modified Jones model. Second, they
construct three dichotomous measures to identify firms that are likely engaging in earnings
management to meet or slightly beat specific benchmarks. The benchmarks they use are market
expectations, avoiding a loss, and avoiding an earnings decline.
10
paper, Ashbaugh, LaFond and Mayhew (2002) find consistent results when replicating
the Frankel et. al paper. 1
There are two dimensions of auditor independence independence in fact and
independence in appearance. Independence in fact requires direct evidence o f the
auditors mental state, whereas independence in appearance can be assessed through
observation o f external facts (SEC 2001 p. 3). The implication is that an auditor is not
independent if a reasonable investor, with knowledge o f all relevant facts and
circumstances, would conclude that the auditor is not capable of exercising objective and
impartial judgement (SEC 2001 p. 3). The Supreme Court,1 1 the SEC, other regulators,
and institutional investors consider independence in appearance a more significant
problem than independence in fact. Former SEC chief accountant Lynn Turner
underscored the importance of independence in appearance as follows: the appearance
of independence not only matters, it is the oxygen that keeps our profession alive...The
staff believes that auditor independence is really about only one thinginvestor
confidence in the numbers and in the markets. 12
The appearance of auditor independence is a theoretical construct of interest in
this paper. I focus on the disclosure of fees paid by audit clients to their external auditors
10 Ashbaugh et al. (2002) also extend Frankel et al. (2002) using the level of non audit fees as an
alternative proxy for auditor independence, an alternative measure for discretionary accruals, and
an analysis that partitions there sample based on income-increasing and income-decreasing
current discretionary accruals. Ashbaugh et al. (2002) use the level of fees paid as a proxy for the
economic importance of a client to an audit firm, i.e. auditor independence risk. In this paper, I
use the ratio of audit fees to total fees as a proxy for the appearance of independence. Different
proxies are necessary between this paper and the Ashbaugh et al. (2002) paper because of the
difference in the underlying theoretical constructs. Ashbaugh et al. (2002) was written
contemporaneously with this paper and many of the innovations found in this analysis were also
considered therein.
11 United States v. Arthur Young and Co., 465 US 805, 819 n. 15 (1984).
^2 Turner (2000) pp. 8-9 Speech by SEC Staff: Current SEC Developments: Independence
Matters.
11
in my analysis, and use the ratio o f audit fees to total fees as a proxy for the appearance
of auditor i n d e p e n d e n c e . 13 The client determines the mix and level o f services that their
auditor provides. 14 Significant levels o f non-audit services may represent an economic
incentive for auditors to maintain positive relationships with their audit clients. It may
also represent an increased risk that auditors would be less inclined to be objective in
performing the audit work, which would impair the auditors independence.
2.2 Prior Audit Committee Research
Klein (2002) examines the relation between the strength of firms corporate
governance structures, including characteristics of firms audit committees, and the level
o f firms earnings management. 15 Klein (2002) finds that the independence of the board
of directors and the audit committee is negatively related to earnings management
measured as the absolute value o f Jones (1991) model abnormal accruals. The results of
13 The SEC does not provide clear guidance on how clients should classify their fees by type.
Information systems and design fees are easily identifiable and classified. However, reported
audit fees may be understated by the cost of registration services and special projects related to
audit work which may be classified by some firms as non-audit services. The result of this
misclassification will be an understatement of the independence level of certain firms which
would bias against my finding results relative to the level of auditor independence and earnings
management.
14 The Public Oversight Board (OMalley Panel) (2000) report suggested that audit committees
approve all non-audit services awarded to its firms external auditor. Many of the
recommendations made by the OMalley Panel have been included in the Sarbanes-Oxley Act of
2002. However, the passage of this act and the publication of the Panels report were after the
majority of the fiscal years examined in this sample were completed.
13 In particular, Klein (2002) considers the percentage of outsiders on the firms audit
committee. In Klein (2002), independence of the board and its committees is measured as the
percentage of outsider directors who are on the board or by using a dichotomous variable equal to
1 if outside directors make up at least 51% of the board/committee and 0 otherwise. The
Sarbanes-Oxley Act (2002) has since mandated that all members of the audit committee be
independent and for at least one member of the committee be a financial expert. The Act does
not address committee size or the number of committee meetings.
12
the study suggest that firms with more independent boards and board committees exhibit
lower levels of earnings management.
I consider a more complete measure of audit committee effectiveness than was
considered in Klein (2002). In addition to the percentage o f outside directors who serve
on the audit committee, I also consider the percentage o f audit committee members who
are financially literate, the number o f meetings held by the audit committee, and the size
o f the audit committee. The BRC recommends that the audit committee be comprised of
100% outsiders and that all of these directors be financially literate. The BRC also
recommends that each audit committee have a minimum of three d i r e c t o r s . 16 Some have
argued that audit committees with as many as six directors are likely to be more effective
(PricewaterhouseCoopers 2000). The BRCs report did not address the number o f times
that audit committees should meet, and the exchanges did not adopt any regulations
regarding the frequency of audit committee meetings. However, the Committee of
Sponsoring Organizations o f the Treadway Commissions study on Fraudulent Financial
Reporting: 1987-1997 found that audit committees o f companies that committed financial
fraud tended to meet only once a year, if at all. Morrissey (2000) recommends that in
order for an audit committee to effectively discharge its monitoring and oversight
responsibility, it should meet at least quarterly to review the interim and annual filings
with the SEC.
16 The NYSE and NASD each adopted rules requiring at least three directors on the audit
committee, all of whom must be independent and financially literate. The NASD specifically
defines what it means by independence and financial literacy. However, the NYSE leaves the
determination of independence and financial literacy up to the individual firms board of
directors.
13
2.3 Are Earnings Management Monitoring Mechanisms
Related?
To date, the extant literature has treated auditor independence and audit
committee effectiveness as independent monitoring mechanisms as they relate to earnings
management (Frankel et al. 2001; Klein 2002). However, both monitoring mechanisms
are a part o f the overall corporate governance structure o f the firm; therefore, it is
unlikely that they operate independent of one another. In fact, the audit committee is
responsible for selecting and retaining the external auditor. 17 Though the external
auditor works with management to complete the quarterly reviews and annual audit, it
ultimately reports to the audit committee. External auditors are motivated to perform
high quality audit work to maintain their reputation and to avoid legal liability. Effects
on reputation as well as legal liability also motivate members of the audit committee to
fulfill their fiduciary responsibility to shareholders through their oversight role of
ensuring the issuance o f accurate financial reports (BRC 1999). Given the similarities in
the objectives of external auditors and audit committees, it is unlikely that these
mechanisms operate independently within the corporate structure or to mitigate earnings
management. This leads me to my first hypothesis:
Hu: Audit committee effectiveness and auditor independence are related.
17 Firm shareholders annually vote on the external auditor. However, the audit committee
submits the accounting firm of their choosing to the shareholders for the vote. It is uncommon
for the accounting firm recommended by the audit committee not to be selected, hi practice,
managers may play a role in the selection of the external auditor; however, their involvement is
not regulated by the SEC and/or incorporation papers of firms. Sarbanes-Oxley 2002 explicitly
states that audit committees have the power to engage and terminate the external auditor.
14
Klein (2002) and Frankel et. al (2001) examine the relation between each
monitoring mechanisms and earnings management independently. However, given the
relation that exists between external auditors and audit committees, there is no reason to
believe ex-ante that they mitigate earnings management independent from one another.
External auditors and audit committees have similar incentiveslegal liability and
reputation effectsand objectivesto issue high quality reports. It is therefore likely
that an interactive relation exists between the two mechanisms in how they mitigate
earnings management. The main effect o f each monitoring mechanism is expected to be
significantly negatively related to abnormal accruals, i.e. reduce earnings management
(Klein 2002 and Frankel et al 2001). The presence o f both monitoring mechanisms
functioning jointly within the firm is likely to have an additional effect on the level of
earnings management.
The manner in which the monitoring mechanisms jointly mitigate earnings
management may be illustrated by the following example. For any given years earnings,
there is a finite amount of earnings management that can be removed. Independent
external auditors are able to remove a portion, as are effective audit committees (Frankel
et. al 2001, Klein 2002). Consider a scenario where there are three firms that are
identical in every respect except in their level o f auditor independence and audit
committee effectiveness. Firm A has a more independent auditor and an ineffective audit
committee, firm B has an auditor who is less independent and an effective audit
committee, and firm C has both a more independent auditor and an effective audit
committee. If the monitoring mechanisms are truly independent o f one another, then the
portion of earnings management mitigated in firm C would be exactly the sum o f the
earnings management mitigated in firm A and firm B. This scenario best represents what
has been done in prior work. However, the effect o f the two monitoring mechanisms
operating at a high level within the firm may lead to an increase in the amount of
earnings management that is mitigated in total. In order for the monitoring mechanisms
15
to increase the level o f mitigation in the scenario presented, the amount of earnings
management mitigated in firm C would have to equal the sum of the mitigated earnings
management in firms A and B plus some additional portion. On the other hand, a decline
in the total amount o f mitigated earnings management implies that there is a portion o f
earnings management that each of the monitoring mechanisms can mitigate equally well.
However, once this portion has been mitigated by one o f the mechanisms, it cannot then
be further mitigated by the other. In the scenario, a decline in overall mitigated earnings
management would lead to the amount of earnings management mitigated in firm C to be
less than the sum of earnings mitigated in firms A and B.
It is the joint effect of the monitoring mechanisms as measured by their
interaction that is excluded from the prior literature. Theoretically, the monitoring
mechanisms are not independent as the audit committee selects the external auditor and
the external auditor reports to the audit committee. Therefore, it is likely that each
monitoring mechanism would influence the manner in which the other mechanism
accomplishes a like goal such as mitigating earnings management. This leads me to the
following hypothesis:
Hib'. The effects o f audit committee effectiveness and auditor
independence on earnings management are related.
The model that I use to test this hypothesis attempts to explain the level o f
earnings management using the two monitoring mechanisms and several control
variables. The main effect of the monitoring mechanisms is captured by the inclusion of
each measure in the multivariate regression. The measure o f how the monitoring
mechanisms jointly mitigate earnings management enters the model as the interaction of
the two variables. This methodology is further explained in Section 3.1 of this paper.
16
2.4 Proxy for Earnings Management
Klein (2002) and Frankel, et al. (2001) proxy for earnings management using the
absolute value of abnormal accruals. Warfield, Wild, and Wild (1995, 78) state that the
absolute value o f abnormal accruals is a proxy for the extent that mangers adjust
reported accounting numbers. Klein (2002) and Frankel, et al. (2001) regress the
absolute value of abnormal accruals on the variables o f interest and several control
variables (absolute value o f abnormal accrual model). I closely replicate the analysis
presented in Klein (2002) and Frankel, et al (2001) using the absolute value model. I also
regress the signed value of abnormal accruals on the same set o f independent variables
(signed abnormal accrual model). While the absolute value transformation of the signed
abnormal accrual simplifies the measure o f earnings management, it also removes
information about the direction o f earnings management. Such information is potentially
important when assessing the impact of auditor independence and audit committee
effectiveness on earnings management.
2.5 Income-Increasing and Income-Decreasing Abnormal
Accruals
While prior research tests the effects o f alternative monitoring mechanisms on

earnings management using the absolute value o f abnormal accruals (Frankel, et al. 2001;
Klein 2002), it is not clear how these results should be interpreted. Consider the results
in Frankel, et al. (2001). They find that the more independent an external auditor, the
lower the level of earnings management as measured by the absolute value o f abnormal
accruals. Smaller magnitudes of absolute abnormal accruals can mean smaller incomeincreasing abnormal accruals, smaller (less negative) income-decreasing abnormal
accruals, or both. There is ambiguity in this interpretation a negative relation between the
17
absolute value o f abnormal accruals and a monitoring mechanism does not necessarily
mean that firms will have income-increasing and income-decreasing abnormal accruals
that are both closer to zero. The question is whether firms with more independent
auditors and/or more effective audit committees have smaller income-increasing
abnormal accruals, smaller income-decreasing abnormal accruals, or both. As
researchers, we care about both the overstatement o f earnings and the accumulation of
cookie jar reserves. As discussed above, the SEC appears to care about all distortions
in earnings, i.e. those that increase earnings as well as those that decrease earnings.
However, whether both audit committee effectiveness and auditor independence mitigate
income-increasing and income-decreasing abnormal accruals equally is an unresolved
question.
Empirical documentation from the extant literature as well as anecdotal evidence
about audit failures suggest that external auditors are more concerned with the
overstatement o f earnings than with their understatement. In a sample o f restatements
from January 1995 to June 1999, Palmrose and Scholz (2000) find that restatements
leading to decreases in revenues (34%) and increases in expenses (28%) represent 62% of
total restatements. Moreover, auditors are frequently investigated by the SEC and sued
by shareholders for allowing earnings to be overstated; however, there is no evidence of
auditors being sued for understating earnings (St. Pierre and Anderson
1 9 8 4
). 18 o f the
restatements examined by Palmrose and Scholz (2000) that resulted in auditor litigation,
79% involved earnings restatements, the majority o f which were downward revenue
adjustments.19 in addition, Nelson, Elliot, and Tarpley (2000) find evidence that
18 This is the most recent empirical study that I am aware of. However, there is substantial
anecdotal evidence that supports this finding.
19 in another paper by Palmrose and Scholz (2001), 91% of the restatements for core issues
(normal, recurring earnings from primary operating activities) decreased net income.
18
external auditors are more likely to allow income-decreasing earnings management than
they are to permit income-increasing earnings management.
The behavior of external auditors is likely to be influenced by the possibility o f a
law suit. Clients are often sued when they report earnings that are significantly lower
than their most recent stream o f reported earnings. The lower earnings may be due to an
unexpected negative shock. When this occurs, financial reports from prior periods are
reviewed to see if, in fact, the current reduction in earnings should have been anticipated
and accrued for at an earlier date. In anticipation of negative shocks to the earnings
stream o f clients, independent auditors may encourage firms to understate earnings in
years that do not have negative shocks through the use of income-decreasing accruals.
Based on the evidence cited above, it appears that external auditors will be more
concerned with the overstatement of earnings in an attempt to avoid future litigation and
negative reputation affects. If so, it is likely that external auditors will exert a
conservative bias on their clients. This prediction differs from the findings documented
by Frankel et al., who conclude that firms with more independent auditors have lower
levels o f earnings management, as measured by the absolute value o f abnormal accruals.
Having smaller absolute values of abnormal accruals means lower level of incomeincreasing and less negative income-decreasing abnormal accruals (i.e., average abnormal
accruals closer to zero). I predict that auditor independence results in external auditors
taking a more conservative posture with respect to client reported earnings. In other
words, I expect firms with more independent auditors to exhibit smaller incomeincreasing and more negative income-decreasing abnormal accruals. This leads me to my
second set of hypotheses with respect to signed abnormal accruals:
H2a: Firms with more independent auditors will exhibit smaller incomeincreasing abnormal accruals
H2b: Firms with more independent auditors will exhibit more negative
income-decreasing abnormal accruals.
19
The BRCs report states that the oversight provided by the audit committee and
the board of directors...
...includes ensuring that quality accounting policies, internal controls, and
independent and objective outside auditors are in place to deter fraud, anticipate
financial risks and promote accurate, high quality and timely disclosure of
financial and other material information to the board, to the public markets, and
the shareholders(1999, 20).
Both the AICPA and the SEC issued statements regarding the BRCs recommendation on
open communication among the audit committee, management, and the external auditor.
The AICPA's Auditing Standards Board adopted a policy requiring independent auditors
to discuss with the audit committee the auditors judgment about the quality and not just
the acceptability under GAAP of the companys accounting principles as applied in its
financial statements. The SEC supported this requirement calling for audit committees to
report in the firms proxy statement that they reviewed and discussed certain matters with
management and the auditors (add reverence). They also must note any significant items
brought to their attention and any financial statement items they believe to be materially
misleading in any way (BRC 1999; SEC 1999).
It is clear from the statements made by the BRC and the regulations enacted by
the AICPA and the SEC that the audit committee is expected to ensure the transparency
and integrity o f financial reporting (BRC 1999, p. 19). Improving audit committee
effectiveness is expected to lead to higher quality financial reporting (BRC 1999), i.e.,
earnings that reflect less earnings management. Therefore, when audit committees are
operating as the AICPA and SEC intends, abnormal accruals should be closer to zero.
However, the empirical evidence supports the notion that audit committees are
concerned with the reputation and liability effects o f being sued for overstating earnings.
Similar to external auditors, there is no evidence o f audit committees being sued for
20
understating earnings. Therefore, it is more likely that the financial reality o f lawsuits
and loss o f reputation will motivate audit committees to constrain firms from overstating
earnings. This leads me to my third set o f hypotheses:
H 3 a: Firms with more effective audit committees will exhibit smaller incomeincreasing abnormal accruals.
H 3 b: Firms with more effective audit committees will exhibit more negative
income-decreasing abnormal accruals.
21
CHAPTER 3. RESEARCH DESIGN
3.1 Empirical Model
Consistent with Frankel, et al. (2001) and Klein (2002), I use multivariate
regression analysis to address my research questions. However, unlike these previous
studies, I include auditor independence, audit committee effectiveness, and an interaction
term between these two variables in the model. These modifications to the established
models allow me to determine both the main and interactive effects o f auditor
independence and audit committee effectiveness on earnings management. If the
monitoring mechanisms function to increase, decrease, or to not change the level o f
mitigated earnings management then the sign o f the coefficient on the interaction term
will be negative, positive, or zero, respectively.20 The regression model is specified as
follows:
AA _ ABS = a + P[AUD_ IND + P 2AUD _ EFF + p z AUD _ IND *A U D _ EFF

+ p AC F O _D E F + p sC FO _ABS + p 6SIZE + p nLEV + P%ANI + p 9POOR
The absolute value o f abnormal accruals (AA_ABS), estimated using the Jones Model, is
used to proxy for earnings management. The independent variables o f interest are auditor
independence (AUD_IND), audit committee effectiveness (AUD_EFF), and the
interaction o f these two variables. The various control variables included in this
specification are defined in the following sub-section. Auditor independence is estimated
20 This prediction is derived from the findings in prior work that the relation between each of the
monitoring mechanisms and earnings management is negative (Frankel 2001 and Klein 2002).
22
as the ratio of fees charged for audit services to total fees.21 Audit committee
effectiveness is a composite measure of four components: size o f the audit committee,
percentage o f outsiders on the audit committee, financial expertise of audit committee
members, and the number of meetings the audit committee held during the year. The first
principal component o f the four measures is used to construct the composite measure of
audit committee effectiveness (see Appendix A) and is converted to a dummy variable
equal to
when audit committees are effective and zero otherwise.
The interpretation of the main effects and the interaction between the monitoring
mechanisms is straightforward because AUD EFF is a dummy variable. Thus,
coefficient p? quantifies the shift in the intercept term that occurs when audit committees
are effective (hypothesis 3a and 3b). pi measures the main effect o f auditor
independence when audit committees are ineffective (hypotheses 2a and 2b). The
interaction between the two monitoring mechanisms is measured with the coefficient P3
(hypothesis lb). Effectively, P3 measures the incremental difference in the slope
coefficient on auditor independence when audit committees are effective ( P 1 + P 3 ) relative
to ineffective (Pi). This incremental difference quantifies the joint effect o f the
monitoring mechanisms to mitigate earnings management, i.e. do they increase, decrease,
or not change the level of mitigation. If the relative change in the slope (P 3 ) is negative
(positive), the interpretation is that as audit committees become more effective,
independent auditors mitigate more (less) earnings management.
21 This measure is different from that used in Frankel et al. (the ratio of non-audit service fees
over total service fees). This modification enables the predictions for auditor independence and
audit committee effectiveness to be in the same direction. This measure also different from the
proxy for auditor independence used in Ashbaugh et al. (2002). These authors measure auditor
independence using the level of total fees paid to the auditor. As discussed in footnote 10, the
theoretical constructs of interest are different in this paper relative to Ashbaugh et al. (2002).
23
Consistent with prior research, my dependent variable is a proxy for earnings
management, which I initially estimate as the absolute value o f abnormal accruals
(A A A BS). Abnormal accruals are estimated using the cross-sectional Jones model
(DeFond and Subramanyam 1997; DeFond and Jiambalvo 1994). This estimation
procedure begins with the following equation:
TA = fl + P\&REV +
+s
where total accruals (TA) is income before extraordinary items (Compustat annual data
item #123) minus cash flows from operations (Compustat #308) and operating cash flows
from discontinued operations (Compustat #124), scaled by beginning of year total assets
(Compustat #4 ).22 The change in net revenues (AREV) (Compustat #302) and gross
property, plant, and equipment (PPE) (Compustat #14) are also scaled by total assets at
the beginning o f the year. This model is estimated separately for each two digit SIC code
grouping. A minimum o f ten firms are required in each two digit SIC code for the group
to remain in the sample. Using the estimated coefficients from equation (2), I estimate
the normal component o f total accruals (NA) for each firm:
NA = a + b l [AREV]+ b2PPE + e
(3)
The a, bi. and 6 2 parameters are the estimation of coefficients a , Pi, P2 , respectively. The
error term from equation (3) is used to proxy for signed abnormal accruals (AA SIGN):
22 Collins and Rebar (2001) document that the calculation of total accruals suffers from
measurement error due to current year mergers, acquisitions, dispositions, and foreign currency
translations. This estimation problem is corrected by taking a cash flow statement approach
which I use in this paper.
24
AA _ SIGN = TA (a + b\ [AREV]+ b2PPE)
(4)
The absolute value o f signed abnormal accruals (AA_ABS) is used as the dependent
variable in equation (1). Later specifications will use the signed abnormal accruals
(AA SIGN) as the proxy for earnings management.
3.1.1 Control Variables
I include control variables in equation (1) to avoid the correlated omitted variable
problem that arises when known factors that affect abnormal accruals are excluded from
empirical models. With respect to earnings management, there are several determinates
o f abnormal accruals that have been documented in the literature. Specifically, prior
research has found a positive relation between abnormal accruals and financial leverage
measured by total liabilities (Compustat #181) divided by total assets (LEV).-3 In
addition, prior research shows that Jones-type models fail to completely extract normal
accruals that are correlated with firm performance (Dechow, Sloan, and Sweeney 1995;
McNichols 2000). Therefore, I include two measures o f firm performance as control
variables; these are cash from operations (CFO_DEF) (Compustat #308) and the absolute
23\Varfield, Wild, and Wild (1995); Dechow, Sloan and Sweeney (1995); DeFond and Jiambalvo
(1994); Becker, DeFond, Jiambalvo and Subramanyam (1998); Dechow, Sloan and Sweeney
(1996); and Bartov, Gul and Tsui (2000).
25
value of cash from operations (CFO_ABS), each deflated by average total assets
(Frankel, et al. 2001).24
Klein (2002) documents a relation between characteristics o f the audit committee
and poor firm performance in the prior two years, the value of the change in net income,
and firm size. Several other papers find a significantly positive association between
earnings management and firm size (Warfield, Wild, and Wild 1995; Dechow, Sloan, and
Sweeney 1995; Frankel et al. 2001; Klein 2002). Following Klein (2002), I control for
each of these variables. An indicator variable (POOR) is set equal to 1 if earnings are
negative in both o f the previous two years, and zero otherwise. The change in net income
is measured as the difference in current and prior year income before extraordinary items
scaled by beginning of year assets (ANI). The log of beginning o f the year assets (SIZE)
is used to proxy for firm size.25
Several o f the control variables included in equation (1) may help to correct the
specification error in the Jones-type models, but they may also proxy for the incentives of
firms to manage earnings. These control variables are negative earnings over the prior
two years, change in earnings, and signed and absolute value of operating cash flows.
Generally, poor performance and income smoothing are primary reasons for firms to
engage in earnings management (Burgstahler and Dichev 1997). Including variables that
proxy for both specification error and incentives could potentially lead to a removal o f
24 There is empirical evidence that abnormal accruals are biased for extreme values of earnings
and cash flows (Dechow, Sloan and Sweeney 1995).
25 Firm size has also been used as a proxy for political costs.
26
some of the information in abnormal accruals that I am trying to explain. This removal
would bias the model against finding the intended results. However, to ensure that the
control variables are not driving the main results o f my analysis, I estimate equation (1)
with and without the control variables.
3.2 Non-nested Technique
I use a non-nested technique (Davidson and MacKinnon 1993) to determine if the

independent variables of interest explain the variation in both the magnitude and the
signed value o f abnormal accruals. The non-nested technique is explained in detail in
Appendix B. This method uses the estimated residual from the signed and absolute value
models to determine the ability of the independent variables to explain the information
contained in the alternate dependent variable. This technique can establish whether one
specification dominates the other, neither is well specified, or whether both models are
incrementally well specified. Prior research has determined that the magnitude of
earnings management as measured by the absolute value of abnormal accruals is
significantly associated with each of the monitoring mechanisms in isolation. The non
nested technique will assist in determining if the direction o f earnings management also
has a significant association with each of the monitoring mechanisms.
3.3 Non-svmmetric Model
Prior papers that examine the relation between earnings management and one of
the monitoring mechanisms assume that the observed relation is constant across both
income-increasing and income-decreasing abnormal accruals (Frankel et al. 2001; Klein
2002). However, there are reasons to believe that the relation between earnings
management and the monitoring mechanisms may differ depending on the direction in
26
some of the information in abnormal accruals that I am trying to explain. This removal
would bias the model against finding the intended results. However, to ensure that the
control variables are not driving the main results o f my analysis, I estimate equation (1)
with and without the control variables.
3.2 Non-nested Technique
I use a non-nested technique (Davidson and MacKinnon 1993) to determine if the

independent variables o f interest explain the variation in both the magnitude and the
signed value o f abnormal accruals. The non-nested technique is explained in detail in
Appendix B. This method uses the estimated residual from the signed and absolute value
models to determine the ability of the independent variables to explain the information
contained in the alternate dependent variable. This technique can establish whether one
specification dominates the other, neither is well specified, or whether both models are
incrementally well specified. Prior research has determined that the magnitude o f
earnings management as measured by the absolute value o f abnormal accruals is
significantly associated with each o f the monitoring mechanisms in isolation. The non
nested technique will assist in determining if the direction o f earnings management also
has a significant association with each o f the monitoring mechanisms.
Prior papers that examine the relation between earnings management and one of
the monitoring mechanisms assume that the observed relation is constant across both
income-increasing and income-decreasing abnormal accruals (Frankel et al. 2001; Klein
2002). However, there are reasons to believe that the relation between earnings
management and the monitoring mechanisms may differ depending on the direction in
27
which earnings are being managed. In particular, external auditors are likely to have a
conservative bias. If true, this bias would result in the relation between the absolute
value o f abnormal accruals and auditor independence to move in opposite directions over
the income-increasing and income-decreasing ranges of the distribution of abnormal
accruals. Thus, it seems appropriate to separately examine the relation between the
monitoring mechanisms and earnings management over both the income-increasing and
income-decreasing ranges.
At first blush, it may appear reasonable to simply split the sample into those firms
that experience income-increasing abnormal accruals and those that do not. However,
this procedure has econometric problems when ordinary least squares (OLS) is used. For
a split sample, OLS leads to biased intercepts and slope coefficients (Davidson and
MacKinnon
1 9 9 3
).26 The bias in the intercepts is not of great concern because it does
not affect the interpretation on the variables o f interest. However, the bias induced in the
slope coefficients makes their interpretation difficult. Statistical tests on the split sample
can be performed if the dependent variable is converted into a dichotomous variable and
a probit model is used. However, this sort of transformation removes the scale of the
dependent variable, leading to a less powerful test.
Given the difficulties with the techniques described above, I fit a censored nonsymmetric model to estimate coefficients on the monitoring mechanisms within the
income-increasing and income-decreasing ranges o f abnormal accruals. This technique is
described in more detail in Appendix C. This model allows the coefficients on the
independent variables to differ based on the direction o f the earnings management.
26 The bias in the intercept arises because the error terms from each sub-sample are not mean
zero. The bias in the coefficients is due to the correlation between the error term and the
independent variables. The direction of the bias cannot be predicted because it is determined by
the characteristics of the data (Davidson and MacKinnon 1993).
28
Because the model is censored (i.e., estimated over a specific range o f the dependent
variable), least squares is not an appropriate estimation technique (Davidson and
MacKinnon 1993). All o f the statistics from the non-symmetric model are calculated
using maximum likelihood estimation where normality is assumed. Maximum likelihood
estimators produce consistent estimates o f the coefficients and error terms (Davidson and
MacKinnon 1993).
29
CHAPTER 4. SAMPLE, EM PIRICAL RESULTS,
AND ADDITIONAL ANALYSES
4.1 Descriptive Statistics
The staff o f the Chief Accountant at the SEC collected detailed audit fee data for
563 Fortune 1000 firms for fiscal year 2000 from their 2001 proxy statements, and this
data set was made available to me. From this sample, I exclude all financial institutions
(SIC codes 6000-6999) because the estimation o f abnormal accruals using the Jones
model is problematic for firms in this SIC code (24 firms). I then collect all necessary
audit committee data from the 2000 and 2001 proxy statements available from
10Kwizard.com as well as relevant financial data from C o m p u s t a t . 2 7 Complete financial
and proxy data were not available for 164 and
72
firms, respectively, which further
reduced the sample to 303. Table ID summarizes the sample selection procedures.
Panel A o f Table 2D shows the industry classification o f my sample of firms. For
comparison purposes, I also report data for the sample firms from Frankel et al. (2001)
and for the Compustat population that meet the screening requirements. An examination
of Table 2D reveals that firms in my sample are more likely to fall into the durable
manufacturers, retail, and textiles and printing/publishing industries. The largest
industries represented in Frankel et al. (2001) are durable manufacturers, computing, and
retail. The industry composition of the Frankel et al. (2001) sample is correlated with the
27 The 2000 proxy statement documents the individuals who are running for reelection to the
board and who are continuing directors in 2000. The 2001 proxy statement documents the
composition of the board, specific committee information, director compensation, and audit and
non-audit fees paid from fiscal year 2000.
30
Compustat sample at 0.989 while my sample is correlated with the Compustat and
Frankel et al. (2001) samples at 0.753 and 0.731, respectively. Thus, the Frankel et al.
(2001) sample is more similar to the Compustat population in terms of industry
classification than is my sample.
I report descriptive statistics for my regression variables in Panel B of Table 2D.
The mean (median) ratio of audit fees to total fees is 0.38 (0.34), with a range from 0.03
to 1.00. The mean (median) measure o f the 0/1 audit committee effectiveness variable is
0.54 (1.00). On average, the firms in my sample report cash flows from operations equal
to 11% o f their average total assets. Liabilities for these firms represent 64% of their
total assets. The annual change in net income from 2000 to 2001 was 1% of total assets.
Only 4% of the firms in my sample experienced negative earnings in both o f the two
previous years. Panel B also compares my sample to the population of Compustat firms
that meet the screening requirements. The absolute value of abnormal accruals is
significantly smaller in my sample relative to the Compustat population. However, my
sample firms are larger and there are fewer firms with negative earnings in both o f the
two previous years. Because my sample contains large firms that are more profitable,
they are likely to be under greater scrutiny by the SEC than the average firm. This
pressure is likely to make their audit committee and external auditor more sensitive to
concerns about their reputation and legal liability. The remaining regression variables in
my analyses are not significantly different from the population of Compustat firms.
Panel C o f Table 2D compares my sample to samples used in Frankel et al. (2001)
and Klein (2002). All o f my regression variables could not be compared because they are
not all included in the descriptive statistics o f the other two papers. As s h o w in Panel C,
my sample is more comparable to the one used in Frankel et al. (2001) than to the Klein
(2002) sample probably because they are both constructed from 2000 financial data. The
Klein (2002) sample spans the period 1991 through 1993. My sample has a significantly
higher percentage o f non-audit services, cash flow from operations, assets, and leverage;
31
and smaller levels of absolute value of abnormal accruals than does the Frankel et al.
(2001)
s a m p le .2 8
Relative to the Klein (2002) sample, my sample firms have smaller
cash flow from operations and greater assets.

It is apparent from the comparison o f descriptive statistics presented that the
sample examined in this paper is different along several dimensions from the ones
examined in prior papers and from the population o f Compustat firms with available data.
Because my sample is constructed from Fortune 1000 firms, it is not surprising that it
would have greater assets and better firm performance compared to the average
Compustat firm or the firms in Frankel et al. (2001) and Klein (2002). My sample
represents a significant portion o f total assets held by public firms (43%), market
capitalization (36.9%) of public firms, and total revenues earned by public firms (44.3%)
in 2000. Moreover, the significant audit failures and subsequent restatements that have
occurred in the ten years leading up to the revision o f the auditor independence rule and
the establishment o f audit committee effectiveness regulations have come almost entirely
from the set of Fortune 1000 firms. Thus, the sample used in the present study appears to
be consistent with the set of firms targeted by the SEC and exchange officials when the
auditor independence and audit committee effectiveness rules were implemented.
Panel A o f Table 3D shows the correlation matrix of the regression variables.
Hypothesis la predicts that audit committee effectiveness and auditor independence are
substitutes (reinforcing) if their relation is negative (positive). The results shown in
Table 3D indicate that auditor independence is significantly negatively correlated with
28 The higher percentage of non-audit services purchased by the firms in my sample is likely due
to the fact that larger firms purchase more non-audit services than does the average firm. If true,
then the decrease in the level of auditor independence in my sample is a mean effect, which will
not affect the variance of this variable and therefore will not induce a sample specific bias upon
the results.
32
audit committee effectiveness. That is, audit committee effectiveness tends to be higher
when external auditors provide more non-audit services to the firm (i.e., when external
auditors appear to be less independent). Thus, the direction o f the correlation suggests
that these variables are
s u b s t i t u t e s . 29
However, this simple correlation does not imply
that auditor independence and audit committee effectiveness will act as substitutes in
controlling earnings management.
Interestingly, the correlation between the absolute value and the signed value of
abnormal accruals is significantly negative. Thus, the larger the magnitude of earnings
management, the more likely the abnormal accrual is income-decreasing, consistent with
big bath behavior. This suggests that the findings from the previous studies on the
relation between the monitoring mechanisms and earnings management should be
cautiously applied to income-increasing and income-decreasing earnings management
(Frankel et al 2001; Klein 2002). The univariate correlation matrix also shows that the
larger the firm and the larger its cash flows, the lower its level of auditor independence,
as measured by audit fees to total fees. This is a reasonable finding because larger firms
may be more complex and thus require more non-audit services. I control for firm size in
my analyses. Firms with more effective audit committees appear to be less likely to have
experienced negative earnings in both of the two prior years, perhaps because boards with
more effective audit committees are, themselves, more effective in monitoring the
performance o f management and encouraging better firm performance. Or, perhaps,
more successful Arms can afford to have more effective audit committees.
29 The negative association between audit committee effectiveness and auditor independence is
maintained in the multivariate model after controlling for leverage, size, and firm performance.
33
4.2
Absolute Value Versus
Signed Abnormal Accrual Models
The results of the non-nested test (see results in Appendix B) reveal that neither
the absolute value nor the signed models are decisively superior, relative to one another.
This means that both models provide information about how the monitoring mechanisms
influence earnings management. Because this analysis does not conclusively find that
one of the models is superior to the other, I consider both the absolute value and signed
model in my analyses (see results reported in Tables 4 and 5). The absolute value model
most closely mirrors the models used in prior work (Frankel, et al. 2001, Klein 2002).
The signed value model represents an improvement in the measure o f earnings
management where explanations for both the direction and the magnitude are sought.
4.3
Are Auditor Independence and Audit Committee
Related with Respect to Mitigating Earnings Management?
Tables 4E and 5E report the regression results when absolute value and signed
abnormal accruals are used as proxies for earnings management. Columns (1) and (2) of
each Table presents a replication o f the analyses run in prior work where only one o f the
monitoring mechanisms relation to earnings management is considered at a time
(Frankel et al. 2001; Klein 2002). Column (3) of each Table includes both monitoring
mechanisms, and column (4) contains both the monitoring mechanisms and the
interaction term.30
Column (0) in Tables 4E and 5E are used to address the possibility that the control variables
are driving the observed results. This is discussed in Section S.l.
34
With respect to the results documented in Frankel et al. (2001), I find that the
relation between auditor independence and the absolute value o f abnormal accruals
(Table 4D) is significantly positive for my sample. This suggests that firms with more
independent auditors tend to exhibit greater earnings management, which is contrary to
the Frankel et al. (2001) results and my hypotheses. There are at least two explanations
for the positive coefficient. First, large firms, which comprise my sample, may operate in
a variety of countries, have more complex and independent business segments, be
engaged in mergers and acquisitions, and thus may be more difficult to audit. Providing
additional non-audit services (due diligence, system integration, etc.) to these firms may
enable the external auditor to do a better job o f performing the audit and mitigating
earnings management. Second, the positive coefficient may reflect differences in how
auditor independence mitigates earnings management between income-increasing and
income-decreasing abnormal accruals. Because o f legal liability and reputation effects,
external auditors o f high profile firms, like those represented in my sample, may have a
propensity to mitigate income-increasing abnormal accruals regardless o f their level o f
independence. On the other hand, auditors that are independent may also apply a
conservative bias to income-decreasing abnormal accruals. If this is true, it is possible
that the significant positive relation observed is due to the conservative bias of
independent auditors in the income-decreasing region o f abnormal accruals.
Turning to the results in Table SD, I find auditor independence has a significantly
negative relation with signed abnormal accruals. In other words, the more independent
the external auditor, the lower the level o f signed abnormal accruals. This finding is
inconsistent with the first explanation that large firms are more complex and therefore
more likely to use their external auditor for consulting services. The finding does provide
some support for the second explanation that auditors behave differently based on the
direction o f the earnings management. I further investigate this result below using the
non-symmetric model.
35
The results presented in Table 4D with respect to the influence o f audit committee
effectiveness on earnings management are inconsistent with the findings documented in
Klein (2002). My measure for audit committee effectiveness is not significantly related
to the absolute value o f abnormal accruals, whereas Klein (2002) finds that audit
committee independence is negatively related to the absolute value o f abnormal
accruals.-^ 1 One explanation for the lack o f significance in Table 4D is that the Klein
(2002) sample is constructed from 1991 through 1993. This period preceded the
discussions o f audit committee effectiveness and the BRC, which was established in
1999. Alternatively, there may be more variation in her audit committee variable than
there is in my audit committee effectiveness variable. If so, Kleins (2001a) tests may be
more powerful than the tests in the present p a p e r . 32 a third explanation relates to the
application of the Klein (2002) result to the income-increasing and income-decreasing
regions o f abnormal accruals. The negative sign on audit committee effectiveness in
Klein (2002) implies that the magnitude of income-increasing and income-decreasing
abnormal accruals is smaller (closer to zero) when audit committees are effective. The
significance of the audit committee effectiveness variable would be weakened if the
relation for either the income-increasing or decreasing regions were in the opposite
direction. In particular, if more effective audit committees lead to more negative incomedecreasing abnormal accruals (away from zero) and income-increasing abnormal accruals
31 Kleins (2001a) measure of audit committee effectiveness include one of the following, a
dummy variable equal to one if all the directors on the audit committee are outsiders, dummy
variable equal to one if the audit committee has a majority of outsiders, or a dummy variable
equal to the percentage of outsiders on the audit committee. The percentage of outsiders on the
audit committee is included in my proxy for audit committee effectiveness.
32 Recall that the measure of audit comminee effectiveness that is used in this paper is a measure
of the variation in the regulations adopted by major exchanges (minimum standard) and the more
stringent guidelines recommended by the BRC and discussed in the extant literature.
36
that are closer to zero, the coefficient of audit committee effectiveness would likely be
insignificantly different from zero.
Table 5D provides further insight into the lack o f significance for audit committee
effectiveness observed in Table 4D by considering the signed model. In Table 5D, audit
committee effectiveness is not significantly different from zero when it is considered
separately from auditor independence [column (2 )], or when both monitoring mechanism
variables are in the model [column (3)]. In column (4), the full model, audit committee
effectiveness is significantly negative. On the surface, this result suggests that more
effective audit committees are associated with lower levels o f signed abnormal accruals.
This finding provides preliminary support for the third explanation, that the relation
between auditor committee effectiveness and the magnitude o f abnormal accruals is not
in the same direction for both income-increasing and income-decreasing abnormal
accruals. Below, I will examine this relation using the non-symmetric model to further
clarify these findings.
The coefficient on the interaction between audit committee effectiveness and
auditor independence is not significant in Table 4D (absolute value o f abnormal
accruals). Because the coefficient on auditor independence is not significantly different
from zero it is difficult to interpret the nature of the relation between the two monitoring
mechanisms. On the other hand, both of the monitoring mechanisms are significantly
negative in Table SD, the model specification that uses signed abnormal accruals. The
corresponding coefficient on the interaction term in Table 5D is significantly positive.
The coefficients on the main effects o f auditor independence and audit committee
effectiveness are significantly negative. Simply stated, the rate at which each monitoring
mechanism mitigates earnings management increases as the individual monitoring
mechanisms improves. The significantly positive coefficient on the interaction term has
a corresponding interpretation; the rate at which one monitoring mechanisms mitigate
37
earnings management declines as the other monitoring mechanisms is improves. The
significant coefficient on the interaction term in Table 5D supports hypothesis lb.
For each model specification, I run an F-test to determine if the relation between
auditor independence and earnings management is different when audit committees are
effective or ineffective (i.e., the sum o f Pi and P3 ). In Table 4D, the results indicate that
auditor independence is significantly related to earnings management irrespective of
whether audit committees are effective or ineffective. In Table 5D, a significant result is
only found in the reduced model in Column (1) for the signed value model. In the full
model, it appears that auditor independence significantly relates to earnings management
only when audit committees are ineffective.
Many of the control variables in Table 4D are significant in the expected
direction. Signed cash flows from operations and size are both significantly negative, as
expected. The absolute value of cash flows, change in net income, and two years of
negative earnings are all significantly positive as expected. The proxy for leverage is
insignificantly different from zero. Only two of the firm performance control variables
are consistently significant in Table 5D. Both change in net income and two years of
negative earnings are significantly negative in the model. This indicates that earnings
management increases as reported income increases following two years o f negative
earnings.
I estimate the relation between abnormal accruals and each monitoring

mechanisms and their interaction within the income-increasing and income-decreasing
regions of the distribution o f abnormal accruals. This model allows the relations between
the monitoring mechanisms and abnormal accruals to vary depending on the direction of
the abnormal accrual. The results o f this non-symmetric model are shown in Table 6 D.
38
These results indicate that auditor independence is ineffective in mitigating incomeincreasing abnormal accruals. These findings fail to support hypothesis 2a, which
predicts that firms with more independent auditors have smaller income-increasing
abnormal accruals. The implication is that in my sample, there is not a notable difference
the level of income-increasing abnormal accruals across different levels o f auditor
independence. Specifically, it may be the case that all auditors, irrespective of their level
of independence deter income-increasing abnormal accruals in the same way. This is
most likely the case with the large firms that make up my sample.
However, there does appear to be variation in the level o f income-decreasing
abnormal accruals across levels o f auditor independence. In fact, there is a negative
relation between auditor independence and income-decreasing abnormal accruals. This is
consistent with more independent auditors appearing to exert a conservative bias on their
clients reported earnings income-decreasing abnormal accruals tending to be more
negative when external auditors are more independent in appearance. This finding
supports hypothesis 2 b, which states that firms with more independent auditors have
more negative income-decreasing abnormal accruals.
The results presented in Table 6 D suggest that more effective audit committees
are associated with smaller income-increasing and income-decreasing abnormal accruals.
This finding is consistent with hypothesis 3a and 3b which predict a reduction in earnings
management in both regimes. Effective audit committees appear to induce a conservative
bias on earnings management. Given the litigious climate that exists over the time period
of my sample, it is likely that audit committees prefer managers to accumulate abnormal
accruals that are more negative (more conservative) rather than less negative (less
conservative). Even though less negative income-decreasing abnormal accruals may
make reported earnings more accurate, it may also expose the audit committee and the
firm to adverse litigation and reputation costs. This may particularly be the case with the
large, high-profile firms that comprise my sample.
39
The results documented in Table 6 D for the interaction term are similar to the
results shown in Table 5D. The coefficient on the interaction term in Table 6 D is
significantly positive, indicating that the rate at which independent auditors mitigate
earnings management declines when audit committees are effective. This finding
provides additional support for hypothesis lb that these two monitoring mechanisms are
not independent with respect to their affects on earnings management.
Except for leverage, the signs o f the coefficients on the control variables in the
income-increasing and income-decreasing sides of the distribution are in opposite
directions. For the income-increasing (decreasing) sub-sample, signed operating cash
flows and size are both significantly negative (positive) and the absolute value of
operating cash flow, change in net income and two years o f negative income are
significantly positive (negative). In the pooled total sample (Table 6 D), signed operating
cash flows and size are significantly positive and the absolute value o f operating cash
flows, change in net income, and two years of negative earnings are all significantly
negative. The measure o f leverage is negative in all three samples.
40
CHA PTER 5. SENSITIVITY ANALYSES
5.1 Incentives Versus Control Variables
As discussed in Chapter 3, some of the control variables included in the model

may be correlated with incentives for firms to manage earnings. The purpose o f
including these variables in the model is to correct for misspecification in the Jones type
models as well as to control for variables that have been found in prior research to
explain variations in abnormal accruals. However, to ensure that the control variables are
not driving my results, Column (0) in Tables 4E and 5E estimate equation (1) without any
of the control variables. With respect to the absolute value model shown in Table 4D, the
results o f the reduced model are not significantly different from those documented in the
full model (i.e. only auditor independence is significant). However, as shown above, this
model may not be as informative as the signed model because it treats income-increasing
and income-decreasing earnings management the same. The results documented for the
signed value model in column (0) of Table 5D shows that the coefficients on both
monitoring mechanisms are significantly negative as predicted. Moreover, the coefficient
on the interaction term is significantly positive. The results from column (0) o f Table 5D
indicate that the findings documented in the full signed value model are not driven by the
control variables.
When the control variables are removed from the estimated models as shown in
column ( 0 ), the explanatory power of the two monitoring mechanisms and their
interaction as measured by R-Squared and Adjusted R-Squared significantly decline. RSquared and Adjusted R-Squared measure the fit o f the model, i.e., the models ability to
predict the dependent variable or explain the majority o f its variation, hi spite o f the
decline in these measures, the model continues to be significant as measured by the F
41
statistic. The F statistic is a test o f the hypothesis that all o f the coefficients in the model
are zero except for the intercept termis the model significant as a whole (Greene 2000).
A significant F statistic is inconsistent with this hypothesis. Therefore, irrespective o f the
decline in the goodness o f fit o f the model in its reduced form, the model continues to
have the ability to identify significant relations between the monitoring mechanisms and
my proxies for earnings management. In this paper, I am not using the monitoring
mechanisms to predict the level o f earnings management across firms. Rather, I am
trying to detect significant associations. Because o f this, it is not necessary for my
variables of interest to explain a large portion o f the variation in the dependent variable;
they need only to be significant to show an association.
5.2 Controlling for Firm Performance
The results that I document above may be due to research design choices that I
have made, specifically the use of the Jones model, to estimate a proxy for earnings
management. Estimates from Jones model has been criticized for yielding poor proxies
for earnings management due to the possibility that a portion o f the measurement error in
these variables are correlated with firm performance variables that are omitted from the
examined model (Benard and Skinner 1996; Guay, Kothari and Watts 1996; Dechow,
Sloan, and Sweeney 1995; Kasznik 1999; Bartov, Gul and Tsui 2000; and Kothari, Leone
and Wasley 2001). Prior research attributes much o f the measurement error in the
estimates of abnormal accruals to firm performance. If either o f the monitoring
mechanisms I investigate in this study are correlated with firm performance, then the
results I document above may be induced by this correlated omitted variable. There are
two ways o f addressing the correlated omitted variable problem. First is to include
proxies for firm performance in the model examined. As discussed in section 3.1.1 and
5.1, several o f the control variables that I have included in the model can be viewed as
42
proxies for firm performance as well as proxies for other theoretical constructs.
Moreover, these variables have been used in prior papers to address the firm performance
criticism. A second way to address the measurement error issue attributable to firm
performance is to attempt to remove the effects of firm performance from abnormal
accruals. Prior papers have used a matched portfolio or firm approach to adjust estimated
abnormal accruals to remove the effect o f firm performance (Kasznik 1999; Bartov, Gul
and Tsui 2000; Kothari, Leone, and Wasley, 2001). In an attempt to show that the results
presented above are invariant to firm performance, I rerun the analyses from my main test
presented in Table 6 D using the matched portfolio approach introduced by Kasznik
(1999).33
Kasznik (1999) ranks the population of Compustat firms into their percentile
grouping based on a measure o f firm performance, specifically, the level o f earnings
scaled by lagged total assets (ROA type metric). He computes a 95% confidence interval
around the mean abnormal accrual in each percentile grouping and tests for the null
hypothesis that abnormal accruals equal zero. The null is rejected in the extreme 20% of
the percentile distribution indicating that firms with low/high levels o f earnings have
negative/positive abnormal accruals. This analysis provides support for the conjecture
that firm performance and abnormal accruals are in fact correlated.
To control for the potential bias that may arise due to the correlation, Kasznik
(1999) removes the percentile groupings mean abnormal accrual from each o f his sample
firms. First, he sorts the sample firms into the percentile groups and calculates the mean
o f each grouping. He then subtracts the percentiles mean measure o f abnormal accrual
33 The matched firm approach is used by Kothari, Leone, and Wasley (2001). For each
treatment firm, the authors select the firm from its corresponding two digit SIC code which has
the closest return on asset. The adjusted abnormal accrual is then calculated as the difference
between the abnormal accruals for the treatment firm and that of the matched firm.
43
from the abnormal accrual measurement of each sample firm. This adjusted figure is
used as his proxy for earnings management. In the spirit of Kasznik, I construct the 100
percentile groups and recalculate the 95% confidence levels for the population of
Compustat firms in 2000 that have the data necessary to calculate abnormal accruals. I
then de-mean the abnormal accruals of firms in my sample firms using the corresponding
percentile groupings mean. Lastly, I recalculate the results in Table 6 D using the
adjusted signed abnormal accrual (SIGN ADJ) figure and report the results in Table 7D.
The results documented in Table 6 D indicate that audit committee effectiveness
mitigates income-increasing earnings management and that both monitoring mechanisms
induce a negative bias on income-decreasing earnings management. The results reported
in Table 7D support those reported in Table 6 D with one exception. The adjusted model
indicates that more independent auditors also mitigate income-increasing earnings
management. This finding supports the SECs basic premise in implementing the new
auditor independence rulethat independent auditors improve the quality of financial
reporting. In summary, the empirical results of this analysis provide additional evidence
that the rules implemented by the SEC are significantly associated with conservative
financial reporting.
5.3 Incentives to Manage Earnings
One weakness o f this paper is that it examines the role o f auditor independence
and audit committee effectiveness in mitigating earnings management without identifying
a group of finns that have strong incentives to manage earnings. Prior research has
identified firms that meet or just beat specific benchmarks as firms that have incentives to
manage earnings (Burgstahler and Dichev 1997; Degeorge, Patel and Zeckhauser 1999;
Dechow, Richardson, and Tuna 2000, Frankel et al. 2001). Reconsidering my primary
44
research questions for firms that have an incentive to manage earning should strengthen
the power o f my tests.
The concept behind the benchmark beating papers is that there is some known
earnings benchmark that firms are trying to meet or beat. Failure to meet or beat
benchmarks has been shown to result in reductions in stock price (Barth, Elliott and Fin
1999, Bartov, Givoly and Hayn 2002, Skinner and Sloan 2002). Researchers have
operationalized the markets expectations using last periods earnings (EARNPRIOR),
earnings greater than zero (EARN_ZERO), and the consensus analysts forecast of
e a r n i n g s . 34
i estimate EARN PRIOR and EARN_ZERO, using the Burgstahler and
Dichev (1997) methodology. EARN_PRIOR equals one if a firm reports a change in

earnings from the prior year scaled by beginning market equity that is greater than or
equal to zero or less than 0.02 and zero otherwise. EARN_ZERO equals one if a firms
reports earnings that are greater than or equal to zero or less than 0.04 and zero otherwise.
Similarly, I construct indicator variables for firms that just miss the benchmark.
EARN_PRIOR _MISS equals one for firms with earnings changes that are less than zero
and greater than -0.02 and zero otherwise. EARN ZERO _MISS equals one for firms
with reported earnings that are less than zero and greater than -0.04.
The model that is
estimated for firms that beat the benchmark (BEAT) versus those that just miss the
benchmark (MISS) is estimated as follows (control variables are excluded from Equation
5 for simplicity):
34 Frankel et al. (2001), Degeorge et al. (1999), and Dechow et al. (2000) also consider firms that
slightly beat market expectations measured using First Call consensus (median) forecasts. I do
not include this measure because there is increasing evidence that firms manage the expectations
of the market through voluntary disclosure (Schwartz 2001). As firms influence the forecasts of
analysts, it is difficult to identify firms that slightly beat market expectations through managing
earnings or managing market expectations.
45
SIGN _ ADJ = a + PxAUD _ IND + P2AUD_ EFF + P,.A UD _ IND *A U D _ EFF +
(5,B EA T+ P5MISS + P6BEAT* AUD _IND + p 1BEAT*AU D _ EFF +
(5)
P%BE A T* AUD _ IND *A U D _ EFF + P9MISS * AUD _ IND +
P 0M ISS* AUD _ EFF + /?,XMISS * AUD_ IND* AUD _ EFF
When the benchmark is zero earnings, there are 67 firms that just beat and 18
firms that just missed zero earnings. The mean (median) signed abnormal accrual is
-0.01 (-0.01) for firms that just beat zero earnings and -0.06 (-0.04) for firms that just
missed zero earnings. The mean (median) signed abnormal accrual adjusted for firm
performance is 0.02 (0.01) for firms that just beat and -0.07 (-0.07) for firms that just
missed last years earnings. Relative to the zero earnings benchmark, firms that just miss
have consistently smaller mean (median) abnormal accruals than those that just beat the
benchmark. The relative means (medians) of the proxies for earnings management are as
expected, i.e. just beat firms should have abnormal accruals that are larger than those of
just miss firms.
When the benchmark is prior years earnings, there are 98 firms that just beat the
mark and 74 firms that just miss it. The mean (median) signed abnormal accrual is -0.01
(-0 .0 2 ) for firms that just beat prior years earnings and -0 . 0 0 (-0 .0 1 ) for firms that just
miss prior years earnings. The mean (median) signed abnormal accrual adjusted for firm
performance is 0 . 0 1 (-0 .0 0 ) for firms that just beat prior years earnings and 0 . 0 0 (-0 .0 0 )
for firms that just missed prior years earnings. The relative means (medians) o f the
earnings management proxies are not as expected. This factoid o f the data may make it
difficult to interpret the results from this cut o f the data.
The estimation o f equation (5) for firms that just beat/miss zero earnings is
reported in Table 8 D. The results indicate a significantly larger intercept for firms that
just beat this benchmark relative to firms that just miss it. Moreover, auditor
independence appears to have a more significant relation with earnings management for
just beat firms than for the average firm. However, there is not a significant difference
46
between the coefficient on auditor independence between the just beat and just miss sub
samples. One interpretation o f this result is that independent auditors mitigate earnings
management in general, but their mitigation efforts are more pronounced when firms are
in the slightly beat category relative to the average firm. In addition, audit committees
appear to be significantly more effective in mitigating earnings management in the just
miss sub sample relative to the just beat sub sample. It may be the case that the firms
identified in the just miss case are firms that would have been in the just beat sub sample
had the audit committee for these firms been less effective.
None o f the comparative results of interest are significant for firms that just
beat/miss prior period earnings. There does not appear to be a significant difference in
how audit committees and independent auditors mitigate earnings management for firms
that just beat/miss prior period earnings. The lack of findings within these sub samples
may be due to the reduced predictive power o f the model as measured by the models F
value. The failure to find results may also be attributable to the unexpected ranking of
mean (median) abnormal accruals between sub samples.
5.4 Follow-up Work
A major criticism of this analysis may be that it only examines one year o f data.
This is a valid criticism because abnormal accruals reverse and the results that I
document may move in the other direction in the following year(s). Data limitations
prevent me from examining the next several years. However, I intend to update my
sample with 2001 and 2002 data as it becomes available to ensure that the results I
document for 2 0 0 0 are not unique.
47
CHAPTER 6. CONCLUSION AND SUMMARY O F

FINDINGS
Several recent high profile cases of accounting irregularities that have led to
billions o f dollars o f market value losses have prompted regulators to take actions to
address perceived audit failures. The SEC recently updated the auditor independence
rules and has spearheaded efforts to have major exchanges implement regulations aimed
at improving the effectiveness of audit committees. This paper provides empirical
evidence on whether (the appearance of) auditor independence and audit committee
effectiveness mitigated earnings management for large firms in fiscal year 2000. I
estimated the appearance of auditor independence with the ratio o f audit fees to non-audit
fees as reported in the proxy statements of clients. My measure for audit committee
effectiveness is calculated using four characteristics of audit committees identified by the
Blue Ribbon Committee on Improving the Effectiveness of Audit Committees and the
extant literature as improving the oversight functions o f this body (size o f the audit
committee, the percentage of outsiders on the committee, number o f directors with
financial expertise, and the number of times the committee met during the year).
From a model specification perspective, future research in earnings management
should consider performance adjusted signed abnormal accruals and thus the direction o f
earnings management. The results documented in this paper demonstrate that findings
based on the absolute value model may be misleading because the relation observed
therein is not symmetric across income-increasing and income-decreasing earnings
management. Moreover, analyses using performance adjusted earnings management are
more powerful than those that do not.
Using a non-symmetric model, which allows the coefficient on the independent
variables to differ based on the direction of the earnings management, I find that both
monitoring mechanisms induce a conservative bias on income-decreasing earnings
48
management, but only audit committee effectiveness appears to mitigate incomeincreasing earnings management. The finding for audit committee effectiveness is
contrary to my initial hypothesis that effective audit committees would mitigate incomedecreasing earning management. It may be the case that in fiscal year 2000, legal
liability and reputation concerns induced most external auditors o f large firms to mitigate
income-increasing earnings management. This is possible considering the wellpublicized audit failures of the late 1990s and may be why I did not observe auditor
independence being related to income-increasing abnormal accruals in my main test.
However, in a sensitivity analysis, where I better control for firm performance, I find that
more independent auditors do in fact mitigate income-increasing earnings management.
This paper also documents a significantly negative relation between auditor
independence and audit committee effectiveness. In particular, I find that these two
monitoring mechanisms are not independent, as is implicitly assumed in prior research
(Frankel et al. 2001; Klein 2002). Therefore, I investigate whether these two monitoring
mechanisms act to reinforce one another or as substitutes in controlling earnings
management by examining their interaction. In other words, do effective audit
committees and auditor independence interact to deter earnings management? I find that
these monitoring mechanisms are related and act as substitutes in their mitigation o f
earnings management. This finding is o f importance to both regulators and shareholders.
Specifically, it appears that effective audit committees can serve as an effective safeguard
against earnings management in situations where external auditor independence may be
compromised, and vice-versa.
In a follow up analysis, I consider the main finding in this paper for firms that are
likely to have engaged in earnings managementbenchmark beaters. The relation
between earnings management and effective audit committees is significantly larger for
firms that just miss zero earnings than for firms that just beat zero earnings. It may be the
case that effective audit committees restrain firms that would have beat the benchmark to
49
just fail to beat it. Audit committees do not appear to effectively mitigate earnings
management in firms that just beat zero earnings relative to just miss firms. However,
relative to the average firm, the relation between external auditors and earnings
management is significantly stronger for just beat firms. There is not difference in this
relation between just beat and just miss firms.
My measure for audit committee effectiveness is more stringent than that required
by the major exchanges in 2000. My finding of significant results relating audit
committee effectiveness and earnings management, one year after the implementation of
the audit committee regulations, suggests that there is still room for improving the
guidelines governing what constitutes effective audit committees. The major findings
o f this paper indicate that there continues to be ways that audit committees and external
auditor quality may be improved through governmental regulation and shareholder
demand.
In response to the bankruptcy o f Enron (and the subsequent filing o f WorldCom)
Congress passed the Sarbanes-Oxley Act of 2002 (S&O). Enrons August 2001
bankruptcy o f $63 billion was the largest in U.S. history until WorldComs bankruptcy of
107 billion in July of 2002 (Morrissey). It appears that both bankruptcies were the result
o f unethical business practices as well as flawed accounting practices. The Act seeks to
improve the quality o f financial reports and minimize misleading actions o f firms and
related parties through regulation and enforcement actions for publicly traded companies,
external auditors and audit committees. The mandates placed on audit committees and
external auditors echo much of what was included in the BRC and Independence Rule
examined in this paper. Relative to the four characteristics of the audit committee that I
examine in this paper, S&O (2002) addresses two of them. The Act requires that
members o f the audit committee be independent as defined as not received compensation
from the company or its subsidiaries in any capacity other than a board member. The Act
also requires that the committee disclose annually if it has a financial expert. S&O
50
(2 0 0 2 ) does not suggest an ideal committee size or meeting frequency for the audit
committee. However, given the nature o f the explicit responsibilities attached to the
audit committee, it is unlikely that the requirements could be adequately addressed by a
committee that met fewer than four times per year. With respect to external auditors,
S&O (2002) made provisions for the establishment of a Public Company Accounting
Oversight Board to regulate the accounting profession. The Act reiterates the services
that impair the independence of external auditors and adds a stipulation restricting
auditors from any other service that the Board determines, by regulation, to be
impermissible.^^ As it relates to audit committees and auditors, S&O codifies some of
the recommendations from the BRC and the revised regulations in the auditor
independence rule adopted by the SEC. Violators of the tenets of S&O will face stiffer
penalties than those attached to violations of the SEC rules and regulations for audit
committees and independent auditors.
35 S&O (2002) contains the following provisions for external auditors, mandatory partner
rotation, audit committee approval of all work performed by the external auditor, auditor reports
to the audit committee, and a limit on audits performed by firms where one of the key financial
officers worked in the prior year. The act also commissioned the Comptroller General of the
United States to conduct a study on the effects of mandatory rotation or external auditors.
51
APPENDIX A. ESTIMATION O F AUDIT

COM M ITTEE EFFECTIVENESS USING
PRINCIPAL COMPONENTS
I consider four aspects o f audit committee effectiveness in this analysis. They are
the (1) size o f the audit committee; (2) the percentage o f outsiders on the committee; (3)
the percentage o f committee members that are financially literate; and (4) the number of
times the audit committee meets during the year. I measure the size o f the committee
with an indicator variable equal to
for committees with more than three directors and 0
otherwise (AUD SIZE). I define independence more strictly than it is defined by either
o f the two exchanges. The NASDAQ defines an independent director as any director
who receives less than $60,000 from the company for non-director services in a given
year. The NYSE allows each firms board o f directors to determine if a particular
director is independent. Because of the differences between the requirements o f the
exchanges and their variation from the recommendations o f the BRC, I use the BRCs
definition of independence. I classify directors as independent if they have no financial
relation with the company, have never worked for the company, and were not affiliated
with the former parent or predecessor company. I use the percentage o f outsiders on the
board to proxy for the level of audit committee independence (AUD_OUT). I designate a
director as having financial expertise if they have a CPA or similar designation or have
served as a financial officer of a company. The percentage o f directors on the audit
committee with financial expertise is an additional component of audit committee
effectiveness (AUD_FIN). I use the number o f audit committee meetings held by the
audit committee during the year as a proxy for the level o f attention (AUD_MEET)
provided by the committee.
As shown in Panel B of Table 3D, these four variables are not highly correlated
with one another, and therefore appear to proxy for different aspects o f audit committee
52
effectiveness. There are several ways to consider these variables in my analysis. Prior
research has considered the univariate components (Chtourou et al., 2001), an equally
weighted composite score (Abbott et al., 2001), and a ranked composite score (Bushman
et al., 2000). While these procedures have produced significant results, they are all ad
hoc and are not supported by any economic theory. Arguments may be made for why
one o f the components should be more important than any other one; however, even this
approach would be subject to debate. Instead, I use the principal component method
which is an econometric technique that estimates the linear combination of a set of
variables capturing the largest possible amount o f variation in that group. Once
estimated, each variable is weighted by the first principal component and the scored
variables are summed into a composite variable. There are several principal components.
However, the first principal component is a weighted average o f the group of variables in
which the weights are chosen to make the composite variable reflect the maximum
possible proportion o f the total variation in the set. Additional principal components can
be calculated; however, the first principal component has the highest possible generalized
variance of the set o f variables c o n s i d e r e d . 36
I estimate a composite measure o f audit committee effectiveness (AUD_EFF)
using the first principal component. The weights applied to audit committee size,
percentage of outsiders, percentage of financially literate directors, and number of
meetings held using the principal components method are 0.17074, 0.21341, -0.21501,
and 0.06419, respectively. The first principal component explains 62% o f the variance in
the four audit committee variables. I use these weights to score each o f the four
variables. By construction, the newly estimated weighted variables from the first
principal component are mean zero with variances equal to one. The audit committee
36 The jth principal component is orthogonal to the first j-1 principal components.
53
effectiveness variable is coded with a 1 if the sum of these weighted variables is positive,
and 0 otherwise. This method resulted in 161 of the 303 firms in the sample being coded
as a I and the remaining 142 coded a zero. Panel B of Table 3D shows that each o f the
four unweighted components is significantly correlated with the composite variable.
54
APPENDIX B. NON-NESTED MODEL
Models are deemed to be well specified when the independent variables

adequately explain the variation in the dependent variable. Adequate explanation can be
defined as the absence o f any additional variables that significantly explain additional
variation in the dependent variable. With respect to the absolute and signed value
models, I use a non-nested technique to determine whether one model is superior to the
other (Davidson and MacKinnon 1993; Greene 2000).
The absolute and signed value models have identical independent variables and
different dependent variables. The dependent variables are the absolute value of
abnormal accruals and the signed value of abnormal accruals. For simplicity, I describe
this analysis using a matrix algebra framework. The independent variables (auditor
independence, audit committee effectiveness, and the control variables) are defined in the
matrix X where p is the corresponding vector of coefficients. The dependent variables,
AA_ABS and A A SIG N , represent the absolute value o f abnormal accruals and the
signed value o f abnormal accruals, respectively. The estimated models are as follows:
AA _ ABS = X p x + e]
(la)
AA_SIG N = X 0 2+ ^2
(lb)
Each o f these models is estimated to obtain the predicted value o f p (b). The
residual (e) is calculated as the difference between the actual dependent value (AA_ABS
or AA SIGN) and its predicted value (aa_abs=Xbi or aa sign^Xbi). The fitted values
for each equation are generated as follows:
aa_abs = Xb\
55
aa_sign = A2> 2
(2b)
The residual (e) from each model represents information about the corresponding
dependent variable that is not explained by the independent variables. To determine
which model is favored, I use the J-test proposed by Davidson and MacKinnon (1993)
(Greene 2000). I add the residuals from the competing model to the fitted model and
estimate a new regression. Adding the residuals from the competing model effectively
decomposes the error term in the original regression model. The estimated residual (eO
is decomposed into the additional variation explained by the residuals from the
competing model (e 2 ) and the remaining unexplained residuals (r|i). The auxiliary
regressions are as follows:
aa _ abs = (l - a \ )Xb\
+<X\e2
+ rji
aa _ sign = (l - or2 )^>2 + <*2^1 + 72
(3a)
(3b)
where a is a parameter that has been introduced so as to nest the fitted model, equations
(2a and 2b), inside the expanded model. Asymptotically, the ratio of the estimated a over
the standard error o f a is the normal t ratio distributed as standard normal. When a=0,
equations (3a and 3b) collapse into equations (2a and 2b). The proper interpretation of
this result is that the residual from the alternate model does not explain any additional
information about the dependent variable of interest. When a*0, the residual from the
alternate model explains additional information about the dependent variable of interest.
That is, the coefficient on the alternate residual (a) will determine if the information
contained in the other dependent variable in excess o f the independent variables explains
any additional variation in the dependent variable o f interest. If the coefficient on the
56
alternate residual is significant, then the other dependent variable explains a significant
portion o f the dependent variable o f interest in excess of the independent variables.
The following matrix summarizes the method used to determine which model is
superior:
(*2 = 0
<X2*0
ai = 0
Not informative
Absolute value model
ai * 0
Signed model
Rejects both models
where the technique is indeterminable if a is significant or insignificant in both expanded

models. If the parameter is significant in one of the expanded models but not the other,
then the model with the significant a is preferred.
57
APPENDIX C. NON-SYMMETRIC CENSORED
MODEL
The model I use to measure the relation between each o f the monitoring
mechanisms and income-increasing or income-decreasing abnormal accruals is based on
a censored model. The data are censored because the regression is conditional, based on
characteristics of the dependent variable [i.e., whether abnormal accruals are positive
(income-increasing) or negative (income-decreasing)]. Specifically, I allow the
distribution o f the dependent variable (Y) to be equal to one of two equations based on its
sign. I assume that the data that I am working with have the following characteristics:
Y = XP\ + e if y > 0, and
Y - X P2 + ify < 0
where e ~ N(0, a 2). The density for each type of observation is generalized by the
following:
Y>0.
y.
f i nr-*02)
Y<0
where the independent variables are represented by X and the standard deviation o f the
residuals isc. Let d equal 1 when Y >0 and 0 otherwise. The log likelihood function is
the following:
ln(/) = d In / i + (l -d )] n / 2
58
where d equals 0(1), the coefficient measured is for the income-decreasing and incomeincreasing sides of the distribution of abnormal accruals. The distribution of abnormal
accruals is assumed to be normal. However, I am interested in examining the incomedecreasing and income-increasing sides o f the distributions separately. Restrictions
placed on d in the last equation allow the relation o f interest to be observed over specific
regions o f the distribution o f abnormal accruals. This effectively removes the symmetry
of the model.
Least squares estimation techniques are inappropriate for estimating models using
censored data. The method of maximum likelihood is an applicable model when using
censored data. Maximum likelihood estimation seeks to find a set o f parameter estimates
such that the likelihood o f having obtained the actual sample is maximized. Specifically,
the joint probability density for the model being estimated is evaluated at the observed
values of the dependent variable and is treated as a function o f the model parameters
(Davidson and MacKinnon 1993). The vector of estimated parameters are the weights
that maximize this function. The model presented above is estimated using maximum
likelihood, which produces unbiased estimates o f coefficients and error terms (Davidson
and MacKinnon 1993).
59
APPENDIX D. TABLES
Table D l. Sample Selection Procedure
Initial Sample
563
firms
Financial Institutions
24
firms
Missing SIC Code
126
firms
Incomplete Compustat Data
38
firms
Missing/Uncollected
Proxy Statements
72
firms
Final Sample
Firms
Table D2. Sample Descriptive Statistics
Panel A: Distribution of sample bv industrv

Sample
Sample
Frankel et al.*
Diff.
Compustat
Industry Description
Agriculture
0.33
0.30
-0.05
0.15
Mining & construction
0.99
66
2.22
0.97
1.31
Food
Textiles & others
2.97
2.26
10.89
1.51
4.98
-1.45
33
45
148
4.90
17
5.61
2.97
71
2.39
-5.70
-2.98
244
8.20
5.49
3.63
124
4.17
25.08
733
24.65
228
7.67
109
3.67
-0.21
-5.94
13.86
253
8.51
-4.40
3.48
10.11
8.91
344
11.57
1.82
11.56
Chemicals
Pharmaceuticals
Extractive
Durable manufacturers
Transportation
Utilities
Retail
Services
9
11
76
23
29
42
27
7.59
9.57
0.60
-1.14
2.70
6.50
4.30
24.48
6.52
D\
Table D2. Continued
Computers
m .
Total
23
7.59
600
20.17
13.00
21.73
303
100.0
2,974
100.00
0.00
100.00
Panel B: Distribution of regression variables

Variables
Sample
Mean
Sample
Median
Sample
Minimum
Sample
Maximum
Sample
Std. Dev.
AAABS
303
0.07
0.05
0.00
0.34
0.07
0.27
0.20**
AASIGN
303
-0.02
-0.02
-0.34
0.29
0.10
-0.09
-0.06
AUDIND
303
0.38
0.34
0.03
1.00
0.20
AUD_EFF
303
0.54
1.00
0.00
1.00
0.50
AUD IND*
AUDJ5FF
303
0.19
0.13
0.00
0.96
0.22
CFO_DEF
303
0.11
0.09
-0.06
0.34
0.07
-0.14
-0.24
CFOABS
303
0.11
0.09
0.00
0.34
0.07
0.27
0.17
Compustat
Mean
Difference
ON
Table D2. Continued
SIZE
303
8.31
8.26
5.10
12.52
1.18
4.69
-3.62**
LEV
303
0.64
0.65
0.14
1.49
0.18
1.13
0.48
ANI
303
0.01
0.00
-0.26
0.25
0.06
-0.94
-0.94
POOR
303
0.04
0.00
0.00
1.00
0.19
0.36
0.32**
Panel C: Distribution of regression variables compared to prior studies

Variables
Sample
Mean
AAABS
303
0.07
0.130
-0.04**
0.077
0.13
AASIGN
303
-0.02
0.004
-0.01
1-AUDIND
303
0.62
0.50
0.120**
CFODEF
303
0.11
-0.010
0.11**
0.117
-0.018**
CFOABS
303
0.11
0.160
-0.06**
ASSETS
303
12,136.40
1,914.69
10,221.71**
8,960.00
3,179.40**
Frankel et al.
Mean
Diff
Klein
Mean
Diff
Table D2. Continued
LEV
303
0.64
0.52
0.14**
Note:
Variable Definition AA_ABS = absolute value of discretionary accruals, estimated using a cross-sectional Jones model, AA_SIGN =
discretionary accruals, estimated using a cross-sectional Jones model, AUD_IND = the ratio of audit feet to total fees obtained from proxy
statements, AUD_EFF = equal to one if the weighted components of audit committee effectiveness is greater than one and zero otherwise.
The four weighted components of audit committee effectiveness are AUD_SIZE, AUD_OUT, AUD_FIN and AUD_MEET.
AUD_IND*AUDEFF = the produce of AUDJND and AUD EFF, CFO_DEF = cash from operations (Compustat #308) deflated by
average total assets (Compustat #4), CFO_ABS = the absolute value of cash from operations (Compustat #308) deflated by average total
assets (Compustat #4), SIZE = Log of assets at the beginning of the year (Compustat #4), LEV = total liabilities (Compustat #181)
divided by total assets (Compustat #4), ANI = The change in net income before extraordinaiy items (Compustat #18) divided by total
assets (Compustat #4), POOR = equals 1 if income before extraordinary items was negative in the previous two years and zero otherwise
(Compustat #18).
* This data was taken from Frankel, Johnson, and Nelson (2001).
**(*) Denotes significance at a=0.01 (a=0.05) level two tailed.
64
Table D3. Correlation M atrix

Panel A: Correlation matrix o f regression variables (N=303)
CFO_DEF
CFOABS
SIZE
LEV
ANI
POOR
AA_ABS
AASIGN
AUDIND
AUDEFF
AUDIND*
0.285**
-0.156**
0.301**
-0.138*
0.078
-0.165**
0.324**
0.174**
0.042
-0.025
0.101*
-0.190**
-0.131*
0.021
-0.072
0.058
-0.131*
AUDEFF
-0.025
1
-0.059
0.211**
0.210**
-0.118*
-0.121*
-0.114*
CFO_DEF
CFOABS
SIZE
LEV
ANI
POOR
-0.118*
-0.031
-0.163**
0.111*
-0.045
-0.287**
0.274**
0.086
-0.130*
0.998**
-0.033
0.991**
1
-0.122*
-0.121*
0.241**
0.038
-0.012
-0.427**
0.219**
-0.137*
-0.423**
0.219**
-0.136*
1
0.292**
0.000
-0.209**
0.126*
-0.298**
1
0.135*
0.151**
1
-0.140*
-0.016
0.048
-0.431**
-0.429**
0.138*
65
Table D3. Continued

Panel A: Correlation matrix o f regression variables (N=303)
AUD IND
*
AAABS
AASIGN
AUDJND AUDEFF
AUD_EI
AAABS
AASIGN
AUDIND
AUDEFF
AUDIND*
-0.267**
-0.307**
0.123*
-0.023
1
-0.063
0.072
0.084
CFO_DEF
CFOABS
0.019
0.134*
0.140*
SIZE
LEV
ANI
POOR
-0.155**
-0.126*
0.305**
0.190**
AUDEFF
-0.199**
-0.205**
0.022
0.005
-0.191**
-0.110*
0.032
0.080
-0.128*
-0.056
0.066
-0.129*
1
0.173**
-0.108*
-0.107*
-0.259**
0.909**
-0.016
-0.021
0.277**
-0.033
0.090
0.137*
-0.078
-0.131*
1
-0.011
-0.016
0.176**
0.097
-0.047
-0.129*
0.152*
-0.084
1
0.60
0.311**
0.792**
Panel B: Correlation matrix o f components of audit committee effectiveness (N=303)

AUD OUT
AUD SIZE
AUD MEET
AUD FIN
AUD EFF
AUDOUT
0.058
0.041
-0.072
0.344**
AUDSIZE
-0.021
0.064
-0.101
0.499**
AUDMEET
0.014
0.126
0.036
0.128*
AUDFIN
-0.066
-0.091
0.046
-0.568**
AUDEFF
0.321**
0.533**
0.101*
-0.592**
66
Table D3. Continued

Note:
Variable Definition AA_ABS = absolute value of discretionary accruals, estimated using a crosssectional Jones model, AA_SIGN = discretionary accruals, estimated using a cross-sectional
Jones model, AUD_IND = the ratio of audit feet to total fees obtained from proxy statements,
AUD_EFF = equal to one if the weighted components of audit committee effectiveness is greater
than one and zero otherwise. The four weighted components of audit committee effectiveness are
AUD_SIZE, AUD_OUT, AUD FIN and AUD_MEET. AUD_END*AUD_EFF = the produce of
AUD_IND and AUD_EFF, CFO_DEF = cash from operations (Compustat #308) deflated by
average total assets (Compustat #4), CFO_ABS = the absolute value of cash from operations
(Compustat #308) deflated by average total assets (Compustat #4), SIZE = Log of assets at the
beginning of the year (Compustat #4), LEV = total liabilities (Compustat #181) divided by total
assets (Compustat #4), ANI = The change in net income before extraordinary items (Compustat
#18) divided by total assets (Compustat #4), POOR = equals 1 if income before extraordinary
items was negative in the previous two years and zero otherwise (Compustat #18).
Pearson in the upper right and Spearman in the lower left
67
Table D4. Absolute Value of Abnorm al Accruals Model

Equation (1) - Test of Hypothesis (lb)
Regression o f the absolute value o f abnormal accruals on measures o f auditor
independence, audit committee effectiveness, the interaction o f the monitoring
mechanisms, and the control variables.
AA_ABS = a + fixAUD _IND +fi 2 AUD _ EFF + fi2AUD_ IND* AUD_ EFF
+ P4 CFO _ DEF + fisCFO _ ABS + fi6SIZE + fi1LEV + fisANI + fi9POOR
Variables
INTERCEPT
AUDIND
AUDEFF
AUD_END*AUD_EFF
CFO_DEF
CFOABS
SIZE
LEV
ANI
POOR
Predicted
Sign
(0)
(1)
(2)
(3)
(4)
0.05*
0.09**
0.06*
0.05**
0.01
0.06*
0.06**
0.04*
-0.01
0.01
-0.01**
0.01
0.33**
-0.60*
0.88*
-0.01*
0.01
0.31**
.60*
0.88*
-0.01*
0.01
0.31**
0.06**
0.06**
0.06**
0.04**
0.01
-0.58
0.85*
-0.01*
0.01
0.31**
0.06**
ft + ft (F test)
0.06*
R-Squared
Adj. R-Squared
F Value for Model
N
0.02
0.01
2.45*
303
-0.65*
0.90*
0.05*
0.01
0.00
0.01**
0.21
0.20
11.84**
303
0.20
0.18
10.96**
303
0.22
0.20
10.45**
303
0.22
0.19
9.26**
303
68
Table D4. Continued

Note:
Variable Definition AA_ABS = absolute value of discretionary accruals, estimated using a crosssectional Jones model, AUD_IND = the ratio of audit feet to total fees obtained from proxy
statements, AUD_EFF = equal to one if the weighted components of audit committee
effectiveness is greater than one and zero otherwise. The four weighted components of audit
committee effectiveness are AUD_SIZE, AUD OUT, AUD_FEN and AUD_MEET.
AUD_IND*AUD_EFF = the produce of AUD IND and AUD_EFF, CFO_DEF = cash from
operations (Compustat #308) deflated by average total assets (Compustat #4), CFO_ABS = the
absolute value of cash from operations (Compustat #308) deflated by average total assets
(Compustat #4), SIZE = Log of assets at the beginning of the year (Compustat #4), LEV = total
liabilities (Compustat #181) divided by total assets (Compustat #4), ANI = The change in net
income before extraordinary items (Compustat #18) divided by total assets (Compustat #4),
POOR = equals 1 if income before extraordinary items was negative in the previous two years
and zero otherwise (Compustat #18).
69
Table D5. Signed Value of Abnorm al Accruals Model

Equation (1) - Test o f Hypothesis (lb)
Regression o f the signed value of abnormal accruals on measures o f auditor
A A _ S IG N = a + p i AUD _ IND + f)1A U D _ E F F + P}A U D _ IND * A U D _ EFF
+P,CFO _ D E F + P.C FO _ A B S + PJSIZE + p ,L E V + P ,A N I + P,PO O R
Variables
INTERCEPT
AUDJND
AUDEFF
AUDJND* AUD_EFF
CFO_DEF
CFOABS
SIZE
LEV
ANI
POOR
Predicted (0)
Sign
0.01
?
-0.09**
-0.04
(1)
(2)
(3)
(4)
0.02
-0.04
-0.01
0.02
-0.04
0.00
0.00
0.05
-0.10**
-0.05**
0.16
-0.41
0.13**
0.20
-0.47
0.00
-0.05
-0.25**
-0.06*
0.00
-0.05
-0.25**
-0.05
0.12**
?
?
?
9
0.17
0.42
0.00
-0.05
-0.43
0.01
-0.05
?
?
-0.25**
-0.06*
-0.26**
-0.06*
fa + ft (F test)
0.03*
R-Squared
0.02
Adj. R-Squared
F Value for Model
N
0.02
2.57*
303
0.20
0.03
0.08
0.06
3.55**
303
0.07
0.04
3.30*
303
0.8
0.05
3.10**
303
0.10
0.07
3.50**
303
70
Table D5. Continued

Note:
Variable Definition AA_SIGN = discretionary accruals, estimated using a cross-sectional Jones

model, AUD_tND = the ratio of audit feet to total fees obtained from proxy statements,
AUDSIZE, AUDOUT, AUDFIN and AUD_MEET. AUDIND *AUDEFF = the produce of
AUD_IND and AUD_EFF, CFO_DEF = cash from operations (Compustat #308) deflated by
average total assets (Compustat #4), CFO_ABS = the absolute value of cash from operations
**(*) Denotes significance at a=0.0l (a=0.05) level two tailed.
71
Table D6. Non-symmetric Censored Model

Non-symmetric Model - Hypotheses (2a), (2b), (3a), and (3b)
Regression of the signed value of abnormal accruals on measures of auditor
A A _ SIGN = a + /?, A UD _IN D + fl2AUD _ EFF + fi,AU D _ IND A UD _ EFF
+ 0,C FO _D E F +13sC FO _ ABS + f)tSlZE + P ,LE V + fi,A N l + &POOR
Variables
INTERCEPT
AUDIND
AUD_EFF
AUDJND* AUD_EFF
CFO_DEF
CFOABS
SIZE
LEV
ANI
POOR
N
Predicted
Sign
9
?
?
?
?
?
?
Incomeincreasing
-0.13**
0.02
-0.10**
0.31**
-0.66**
1.87**
-0.01**
-0.10**
2.89**
0.06**
106
Predicted
Sign
+
7
7
7
7
7
7
7
Incomedecreasing
0.67*
-0.24**
Total
Sample
-0.09**
0.14**
0.05**
-0.10**
-0.05**
0.14**
3.57**
-4.60**
0.04**
-0.06**
-0.22**
-0.06**
197
0.24*
-0.52**
-0.00**
-0.04**
-0.22**
-0.06**
303
Note:
Variable Definition AA_SIGN = discretionary accruals, estimated using a cross-sectional Jones
model, AUDIND = the ratio of audit feet to total fees obtained from proxy statements,
AUD SIZE, AUDOUT, AUDFIN and AUD MEET. AUD IND*AUD EFF = the produce of
AUD IND and AUD EFF, CFO DEF = cash from operations (Compustat #308) deflated by
average total assets (Compustat #4), CFO ABS = the absolute value of cash from operations
72
Table D7. Non-symmetric Censored Model - Adjusted for Firm Perform ance
Non-symmetric Model - Hypotheses (2a), (2b), (3a), and (3b)
Regression o f the signed value of abnormal accruals on measures o f auditor
SIGN _ ADJ = a + 0 lAUD _IN D + PZAUD _ EFF + P, A UD _ IND * AUD _ EFF
+PtCFO _ DEF + PsCFO _ A B S + PSIZE + P^LEV + P,ANI + P^POOR
Variables
Predicted
Sign
INTERCEPT
AUDIND
AUD_EFF
AUD_IND*AUD_EFF
CFO_DEF
CFOABS
SIZE
LEV
ANI
POOR
N
Incomeincreasing
-0.46**
-0.06**
-0.25**
0.66**
-0.17**
?
?
7
-5.20**
8.19**
-0.03**
0.99**
0.46**
106
Predicted
Sign
Incomedecreasing
0.04
Total
Sample
0.08**
-0.05**
-0.12**
0.14**
-0.08**
+
7
7
7
7
-0.32**
-0.11**
0.14**
0.04**
0.00**
?
7
-1.17**
-0.08**
-0.04
303
-0.12**
3.97**
-4.24**
-0.13**
197
-0.10
-0.04**
Note:
Variable Definition, SIGN_ADJ = discretionary accruals, estimated using a cross-sectional Jones
model adjusted for firm performance, AUD_IND = the ratio of audit feet to total fees obtained
from proxy statements, AUD_EFF = equal to one if the weighted components of audit committee
committee effectiveness are AUDJSIZE, AUD OUT, AUD FIN and AUD MEET.
AUD_IND*AUD_EFF = the produce of AUD IND and AUD EFF, CFO DEF = cash from
and zero otherwise (Compustat #18).
73
Table D8. Benchmark Beaters - Earnings G reater than Zero

Equation (5)
Regression o f the signed value of abnormal accruals on monitoring mechanisms, their
interaction with one another and with indicator variables for firms that beat
and firms that fail to meet benchmarks.
SIG N _ A D J =a + A UD _ IND + p 2A UD _ EFF + P,AU D _ IN D * AUD _ EFF +
Pt BEAT + p sMISS + P6BEAT* AUD J N D + p nB EAT* A U D _ EFF +
P,BEA T * A U D J N D * AUD _ EFF + P,M ISS * AUD _ IND +
PSM ISS * AUD _ EFF + Px, MISS AUD _ IND * AUD _ EFF
Variables
INTERCEPT
AUDIND
AUDEFF
AUD IND*AUD EFF
BEAT
MISS
(0)
0.08
-0.12**
-0.06**
0.15**
0.02
-0.07**
BEAT* AUDJND
BEAT*AUD_EFF
BEAT*AUD_END*
AUDEFF
MISS*AUD IND
MISS*AUD_EFF
MISS*AUDJND*
AUDEFF
$7 < &10
&</3
R-Squared
Adj. R-Squared
F Value
N
(1)
(2)
-0.09**
-0.07**
0.17**
0.05
-0.07**
-0.06**
0.15**
0.05
0.08**
-0.12**
-0.25**
0.05*
0.09**
-0.09
-0.29**
0.02
0.08
0.11
-0.02
0.05
-0.08
0.13
0.59
4.05*
0.04
0.08
0.05
2.70**
303
0.13
0.09
3.14**
303
0.13
0.08
2.77**
303
74
Table D8. Continued

Note:
Control variables were included in the estimation of the columns (0) through (2), but are not
reported.
Variable Definition SIGN_ADJ = discretionary accruals, estimated using a cross-sectional Jones
committee effectiveness are AUD SIZE, AUD OUT, AUD FIN and AUD MEET.
AUDIND *AUDEFF = the produce of AUDIND and AUDEFF, CFODEF = cash from
POOR = equals I if income before extraordinary items was negative in the previous two years
and zero otherwise (Compustat #18). INCREASE equals one if the annual change in net income
divided by the beginning year market value of common equity is greater than zero but less than
0.02 and zero otherwise. INCREASE_MISS equals one if the annual change in net income
divided by the beginning year market value of common equity is less than zero but greater than 0.02 and zero otherwise. POSITIVE equals one if net income divided by the beginning year
market value of common equity is greater than zero and less than 0.04 and zero otherwise.
POSmVE_MISS equals one if net income divided by the beginning year market value of
common equity is less than zero and greater than -0.04 and zero otherwise. FORECAST equals 1
if reported earnings exceed the consensus analyst forecast and zero otherwise. BEAT firms that
beat benchmarks as indicated by INCREASE, POSITIVE, and FORECAST. MISS firms that
slightly fail to meet benchmarks as indicated by INCREASE, POSITIVE, and FORECAST.
75
Table D9. B enchm ark Beaters - Earnings G reater than Prior Period Earnings
Equation (5)
Regression o f the signed value of abnormal accruals on monitoring mechanisms, their
interaction with one another and with indicator variables for firms that beat
and firms that fail to meet benchmarks.
SIG N _ A D J = a + /?, A UD _ IND + /32A U D _ EFF + Pi AUD _ IND * A UD _ EFF +
P<B E A T + Pi M ISS+ p BEA T * A U D J N D + p , BEA T * AUD _ EFF +
Pt B E A T * AUD _ IND* AUD _ EFF + /?, M ISS * A U D _ IN D +
PWM ISS * AUD _ EFF + Px,M ISS * AUD _ IND* AUD _ EFF
Variables
INTERCEPT
AUDIND
AUDEFF
AUDIND* AUDEFF
BEAT
MISS
BEAT*AUD_END
(0)
0.07
-0.11**
-0.05**
0.15**
0.03**
0.02
BEAT*AUD_EFF
BEAT*AUD_IND*
AUDEFF
MISS*AUD IND
MISS*AUD_EFF
MISS*AUD_IND*
AUDEFF
0.07
0.08
-0.13**
-0.04
0.14**
0.04
-0.15**
-0.06
0.19**
-0.01
-0.00
0.13
0.05
-0.19
0.00
0.02
-0.02
0.09
-0.03
F Value for Model

N
0.06
0.03
1.98*
303
0.09
-0.02
0.01
0.07
0.03
1.59*
0.87
0.08
0.99
0.08
0.03
1.50*
303
303
& < (F test)

07 < 0io (F test)
08 < 0n (F test)
R-Squared
Adj. R-Squared
(2)
(1)
76
Table D9. Continued

Note:
Control variables were included in the estimation of the columns (0) through (2), but are not
reported.
Variable Definition SIGN_ADJ = discretionary accruals, estimated using a cross-sectional Jones
committee effectiveness are AUD SIZE, AUD OUT, AUD FIN and AUD MEET.
AUD_IND*AUD_EFF = the produce of AUD IND and AUD EFF, CFO DEF = cash from
and zero otherwise (Compustat #18). INCREASE equals one if the annual change in net income
divided by the beginning year market value of common equity is greater than zero but less than
0.02 and zero otherwise. INCREASE_MISS equals one if the annual change in net income
divided by the beginning year market value of common equity is less than zero but greater than 0.02 and zero otherwise. POSITIVE equals one if net income divided by the beginning year
market value of common equity is greater than zero and less than 0.04 and zero otherwise.
POSITIVE_MISS equals one if net income divided by the beginning year market value of
common equity is less than zero and greater than -0.04 and zero otherwise. FORECAST equals 1
if reported earnings exceed the consensus analyst forecast and zero otherwise. BEAT firms that
beat benchmarks as indicated by INCREASE, POSITIVE, and FORECAST. MISS firms that
slightly fail to meet benchmarks as indicated by INCREASE, POSITIVE, and FORECAST.
77
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ProQuest Information and Learning

AUDITOR INDEPENDENCE, AUDIT COM M ITTEE EFFECTIVENESS,

A thesis submitted in partial fulfillment

UMI Number: 3073378

ProQuest Information and Learning Company

This is to certify that the Ph.D. thesis of

To Toby, the spice in my life,

I wish to express my sincerest appreciation to Professors Daniel W. Collins and

LIST OF TABLES................................................................................................................ vii

Table D l. Sample Selection Procedure..............................................................................59

1 Examples of companies that overstated earnings includeCendant, $500 million (CFO

5 Press Release 98-96 SEC September 28,1998 p.l.

2.4 Proxy for Earnings Management

While prior research tests the effects o f alternative monitoring mechanisms on

3.1 Empirical Model

AA _ ABS = a + P[AUD_ IND + P 2AUD _ EFF + p z AUD _ IND *A U D _ EFF

when audit committees are effective and zero otherwise.

AA _ SIGN = TA (a + b\ [AREV]+ b2PPE)

3.2 Non-nested Technique

I use a non-nested technique (Davidson and MacKinnon 1993) to determine if the

3.2 Non-nested Technique

I use a non-nested technique (Davidson and MacKinnon 1993) to determine if the

4.1 Descriptive Statistics

firms, respectively, which further

Relative to the Klein (2002) sample, my sample firms have smaller

cash flow from operations and greater assets.

However, this simple correlation does not imply

Absolute Value Versus

Signed Abnormal Accrual Models

Are Auditor Independence and Audit Committee

Related with Respect to Mitigating Earnings Management?

I estimate the relation between abnormal accruals and each monitoring

CHA PTER 5. SENSITIVITY ANALYSES

5.1 Incentives Versus Control Variables

As discussed in Chapter 3, some of the control variables included in the model

i estimate EARN PRIOR and EARN_ZERO, using the Burgstahler and

Dichev (1997) methodology. EARN_PRIOR equals one if a firm reports a change in

The model that is

CHAPTER 6. CONCLUSION AND SUMMARY O F

APPENDIX A. ESTIMATION O F AUDIT

for committees with more than three directors and 0

APPENDIX B. NON-NESTED MODEL

Models are deemed to be well specified when the independent variables

aa _ sign = (l - or2 )^>2 + <*2^1 + 72

Absolute value model

Rejects both models

where the technique is indeterminable if a is significant or insignificant in both expanded

Table D l. Sample Selection Procedure

Missing SIC Code

Incomplete Compustat Data

Table D2. Sample Descriptive Statistics

Panel A: Distribution of sample bv industrv

Mining & construction

Table D2. Continued

Panel B: Distribution of regression variables

Table D2. Continued

Panel C: Distribution of regression variables compared to prior studies

Table D2. Continued

Table D3. Correlation M atrix

Table D3. Continued

Panel B: Correlation matrix o f components of audit committee effectiveness (N=303)