International Journal of Accounting and Financial Management Research (IJAFMR) ISSN 2249-6882 Vol. 2 Issue 4 Dec 2012 9-24 © TJPRC Pvt. Ltd.,
INDEPENDENT DIRECTORS AND EARNINGS MANAGEMENT – EVIDENCE FROM INDIA HANISH RAJPAL Institute of Management Technology, Nagpur, Maharashtra, India
ABSTRACT The objective of this paper is to analyze the impact of the characteristics of independent directors in a firm on earnings management. Earnings management is the opportunistic use of discretion by managers to alter the financial statements or transactions and achieve a desired outcome in order to mislead some stakeholders or to meet personal objectives. Presence of independent directors in the board of directors may significantly restrict such efforts of managers and constrain earnings management. The study takes a sample of 200 large manufacturing firms listed on National Stock Exchange (NSE) in India for a period of three years and examines the impact of factors, such as presence of independent directors in board, diligent behavior of independent directors, and busyness of independent directors, on earnings management. The results suggest that busyness of independent directors and their quality plays an important role in constraining earnings management. The results also suggest that if the independent directors hold multiple directorships in other companies, due to their diverse expertise and experience, they are able to constrain opportunistic earnings management practices. However, in case independent director holds the position of chairperson in other companies, their busyness adversely affects their ability to constrain opportunistic earnings management.
KEYWORDS: Earnings Management, Independent Directors, Corporate Governance INTRODUCTION Earnings management has captured the interest of practitioners, researchers, regulators, analysts and investors for long. It has been argued that the practices of earnings management was the core issue in the accounting frauds such as Enron, Xerox and WorldCom in last decade and half (Goncharov, 2005). In India, the accounting fraud of Satyam Computers raised similar questions. Due to such events, the integrity of accounting profession as a whole is under scrutiny. Questions on transparency of accounting reports, relevance of accounting numbers and controls to reduce opaqueness in financial statements are the subject of debate in many forums. Several studies have been conducted to assess the value relevance of the accounting numbers. Barth et al (2001) argues that accounting numbers are considered value relevant if there is significant correlation between accounting numbers and market value of equity. Easton and Harris (1991) and Das and Lev (1994) argues that accounting earnings are related to equity returns. However, many studies have found a weak correlation between accounting earnings and returns. Easton et al (1992) argues that the primary reason for such weak correlation is low information content of earnings. Lev (1989) argues, “The low information content is probably due to biases induced by accounting measurement and valuation principles and in some cases to manipulation of reported data by managers” (p.85). This thus raises the questions on quality of reported earnings in an environment where managers have incentives to manage the earnings opportunistically. Several authors have also contended that quality of reported accounting information influences the firm valuation. Prior research shows evidence for income-increasing unexpected accruals prior to initial public offering or seasoned equity
offering and reversal of unexpected accruals following such offerings (Teoh, Welch and Wong, 1998a; Teoh, Welch and Wong, 1998b; Teoh, Wong and Rao, 1998 in Healy and Wahlen, 1999). One of the most quoted definition of earnings management is given by Healy and Wahlen (1999). They define earnings management as “earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers” (p.368). Mulford and Comiskey (2002) (in Rudra and Bhattachajee, 2012) defined earnings management as “the active management of earnings towards a predetermined target” (p.3). Schipper (1989) argues that earnings management connotes that earnings management is management of disclosures by intervening in the financial reporting process with a view to obtain private gains. Thus, these definitions imply that managers manage earnings with a primary objective of personal gains and thus reflect the opportunistic behavior of managers. However, earnings management is not always considered opportunistic. Scott (2003) (in Rudra and Bhattacharjee, 2012) considers earnings management as “a device to convey inside information to market, enabling share price to better reflect the firm’s future prospects” (p.3). Fields et al (2001) state that earnings management may be either opportunistic or firm value maximizing. Thus, earnings management can be opportunistic or informative. Empirical evidences suggest that earnings management are more widely practiced in emerging countries like India than the developed economies like US owing to relatively weaker legal enforcement (Jian and Wong, 2004 in Rudra and Bhattacharjee, 2012.). In a comparative study of 31 countries by Leuz, Nanda and Wysocki (2003) (in Sarkar, Sarkar and Sen, 2008), “India ranked nineteenth in terms of aggregate earnings management score” and categorized as having “highest extent of earnings management”(p.521). Further Bhattcharya, Daouk and Welker (2003) (in Sarkar, Sarkar and Sen, 2008) provide evidence of higher opacity in financial statements of Indian corporations as compared to their counterparts in US. Although there are empirical evidences of widespread practices of earnings management in India, relatively fewer empirical studies have been conducted so far to understand the factors influencing such practices in the India. Chipalkatti and Rishi (2007) (in Rudra and Bhattachrjee, 2012) concluded the adoption of earnings management by low profitability banks in India by under providing the loan loss provisions. Sarkar, Sarkar and Sen (2008) argue that it is the board quality and diligence that reduces the earnings management in India. Rudra and Bhattacharjee (2012) studied the impact of adoption of IFRS on earnings management in India and concluded that only adoption of high quality standards does not reduce the level of earnings management. The problem of opportunistic earnings management primarily revolves around the Agency Theory. The agency theory is based on the principal-agent relationship that is observed in modern organizational structure. The separation of ownership from management brings the agency relationship between owners and managers of the organization. Such separation creates the ground for conflicts between the interests of managers and shareholders (Jensen & Meckling, 1976). The primary basis of agency theory is that their own personal interests and gains rather than the objective of maximizing shareholder’s wealth motivate managers. As per Eisenhardt (1989), the agency problem emerges when “The goals of principal and agent conflict and it is difficult and costly for the principal to verify what the agent is actually doing”. Due to such separation of ownership and management, managers exercise a significant control over allocation of resources. Shleifer and Vishny (1986) contend that the “managers use their effective control rights to pursue projects that benefits them rather than the investors”. Further to the problem of resource allocation, such principal-agent relationship gives rise to information asymmetry. Agency theory, thus, provides the rationale behind the practices of manipulating the accounting
Independent Directors and Earnings Management – Evidence from India
earnings in an environment where managers are entrusted with the powers to exercise discretion and their incentives (performance-linked compensation/bonus) are tied to beating or meeting the earnings target. Corporate governance, in such situations, can be seen as a system with the primary objective to reduce the agency problem. Shleifer and Vishny (1986) define corporate governance “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting return on their investments”. Fama (1980), Fama and Jensen (1983) and Williamson (1988) argue that opportunistic behavior of management can be constrained by both internal and external corporate governance mechanisms. Demsetz and Lehn (1985) also support the argument by stating that the primary objective of corporate governance is to resolve agency problem through monitoring management’s behavior rather than to improve organization’s performance. The governance mechanisms include presence of non-executive directors in the board, audit committee, external audits and ownership structure. Role of directors in effective corporate governance of an organization can never be undermined. “Directors are expected to act independently of management and participate in a thoughtful and diligent decision making process” argues Rath (2010). The role of independent directors was in limelight after the accounting scandals such as Enron and World Com were unearthed. However, their importance in corporate governance setting was acknowledged long before. Cadbury Code of Best Practices (1992) prescribed that board should include non-executive directors of sufficient calibre and that majority of non-executive directors should be independent of management. Sarbanes-Oxley Act of 2002 and listing rules at major US securities markets such as NYSE and NASDAQ also require majority of the board to be independent. In the last decade of the twentieth century, India saw number of financial frauds such as Harshad Mehta Scam, Vanishing Companies Scam, Non-Banking Finance Companies Scam and Ketan Parekh Scam. It was also the time when during early 1990s economic liberalization and financial reforms were introduced. Owing to increased international competition because of economic liberalization and such large financial frauds, the need for more disclosure and better corporate governance was realized. Securities Exchange Board of India (SEBI) and Government of India formed national level committees to recommend measures for improving corporate governance system in India. Composition of board of directors was taken up with utmost deliberation. Kumar Mangalam Birla Committee and Naresh Chandra Committee defined the concept of independent director in almost identical manner. Narayana Murthy Committee later adopted the definition given by Kumar Managalam Birla Committee. The committees also recommended majority of independent directors on the board. SEBI implemented the recommendations of Kumar Managalam Birla Committee report by enacting clause 49 of the listing agreement. Clause 49 is considered as a milestone in the history of corporate governance in India. Later, clause 49 was amended by the recommendations of Narayana Murthy Committee report. The composition and functioning of board in a company is one of the major focus areas of this clause. The clause requires that the board of directors of a listed company should comprise not less than fifty percent non-executive directors. Further, it defines independent directors and provides that for every listed company, in which the chairperson is an executive director, the board should comprise not less than fifty percent independent directors. Where the chairperson is a non-executive director, the board should comprise not less than one-third independent directors. It also lays down norms for maximum number of chairmanships and committee memberships, compensation of directors, frequency of board meetings and disclosures in annual reports. Although there are empirical evidences of improvement in firm performance in emerging countries such China, India and East Asian countries because of existence of independent directors (see Choi, Park and Yoo (2005), Black, Jang and Kim (2002), Han and Wang (2004) and Kumar (2003) in Rath (2010)), there is a limited study on how effective independent directors are in constraining earnings management. Sarkar, Sarkar and Sen (2008) have conducted a notable
study of the effect of board of director’s characteristics on earnings management in India for the period of two financial years viz. 2002-03 and 2003-04. They concluded that board’s quality and diligence rather than independence lowers the level of earnings management. However, for the below two reasons this study is relevant. First, the period of 2002-2004 was the period when the corporate governance rules were newly introduced in India through clause 49 of the listing agreement. These rules have undergone tremendous changes since then. The revised clause 49 of the listing agreement was implemented from Jan 1, 2006 after adopting the recommendations of Narayana Murthy Committee report. Thus, there is a need to study the level of earnings management practices under the light of new norms. Secondly, in recent years the world has undergone severe financial turmoil first due to subprime crisis and later due to the European crisis. Like in other countries, businesses in India have also faced tremendous pressures. Under such adverse situations the conjecture is that managers would have higher motivation for positive (income increasing) earnings management in order to meet the analyst forecast. On the other side, manager may also tend to take a ‘big bath’ and indulge into negative (income decreasing) earnings management practices in order to present better picture in later periods. In any case, the level of earnings management is expected to be high in such adverse economic situations. Therefore, it is important to study how efficiently the independent directors function in constraining earnings management practices. The objective of this paper is to empirically analyze relationship between the attributes of independent directors and earnings management in India. The difference between this paper and Sarkar, Sarkar and Sen (2008) is that Sarkar et al (2008) analyzed the board characteristics, including factors such as CEO duality and promoter influence, on earnings management whereas this paper focuses on the role of independent directors in constraining earnings management. Further, this paper analyzes the busyness and quality characteristics of independent directors in more detail. This study uses a sample of 572 firm-years representing 200 firms in manufacturing sector of Indian for a period of three years and analyzes the relationship between various attributes of independent directors and opportunistic earnings management. The paper examines the effect of independence of board, diligence of independent directors and busyness and quality of independent directors on earnings management. Similar to earlier studies, independence of board is measured by two variable namely proportion of independent directors on board and majority of independent directors in the board. Percentage of meetings attended by independent directors is taken as the proxy for diligence of independent directors. Busyness and quality hypothesis is tested using two variables namely presence of independent directors holding large number of directorships in other companies and presence of independent directors holding the position of chairperson in other companies. The results of this study suggest that busyness of independent directors and their quality plays an important role in constraining earnings management. Unlike other studies (for example Sarkar, Sarkar and Sen, 2008), the results of this study suggest that if the independent directors hold multiple directorships in other companies, due to their diverse expertise and experience, they are able to constrain opportunistic earnings management practices. However, in case independent director holds the position of chairperson in other companies, their busyness adversely impacts their ability to constrain opportunistic earnings management. The rest of the paper is organized as follows. Section 2 reviews the related literature and describes the hypothesis. Section 3 provides the sample data description, variables and research methodology. Section 4 discusses the results and section 5 concludes the paper.
REVIEW OF LITERATURE AND HYPOTHESIS DEVELOPMENT The literature provides variety of factors that motivate managers to manage earnings opportunistically. Healy and Wahlen (1999) argues that “earnings management occurs for variety of reasons, including to influence stick market
Independent Directors and Earnings Management – Evidence from India
perceptions, to increase management’s compensation, to reduce likelihood of violating lending agreements, and to avoid regulatory intervention” (p.380). Burgstahler and Eames (2003) (in Sarkar, Sarkar and Sen, 2008) finds that firms manage earnings to meet analyst forecast. Matsunga and Park (2001) argue that the firm has a considerable negative impact of stock returns if it misses an earnings benchmark. Several researches provide evidence of earnings management immediately before the initial public offering or seasoned public offerings. Stock repurchases is used as the earnings management tool in cases where earnings are below the required level (Bens et al, 2003). Healy (1985) argues that managers manipulate earnings in order to increase their cash compensation. Leuz et al (2003) also asserts that where manager’s compensation, bonus etc. are tied to earnings targets, there is an incentive for managers to manage earnings opportunistically. Several studies have documented a relationship between board independence and earnings management. Xie et al (2003), with a sample of 282 firms finds a negative relationship between proportion of independent directors in the board and level of earnings management. Klein (2002) has also found the similar results with larger number of control variables. Beasley (1996) and Davidson et al (2005) have also found similar results. However, Peasnell et al (2005) and Bradbury et al (2006) found no significant association between earnings management and independence of board. Sarkar, Sarkar and Sen (2008) in study of 500 Indian firms also found that percentage of independent directors does not significantly affect the level of discretionary accruals. In one of the recent studies, Osma (2008) analyses earnings management through research & development spending manipulation and finds that independent directors are capable of identifying and constraining earnings manipulation. Benkel et al (2006) using a sample of 666 firms years in Australia finds that independent boards and audit committees are associated with lower levels of earnings management. Jaggi et al (2009) using a sample of 770 firm years finds that although independent board provides effective monitoring of earnings management practices but in case of family controlled firms the effectiveness of such monitoring reduces.
Thus, there are conflicting results on the
association of earnings management and board independence. Relatively less number of studies focuses on the association between earnings management and the frequency of board meetings. Xie et al (2003) argue that when board meetings are rare, issues such as earnings management may not be on the priority list due to paucity of time. In such cases, the function of the board is reduced to a mere rubber stamp to sign off management plans. Xie et al (2003) finds a significant negative association between earnings management and number of board meetings. Further, it is essential to analyze that even if the board meets frequently, how many directors actually attend the board meeting. Sarkar, Sarkar and Sen (2008) in a study of 500 manufacturing firms in India find that board diligence i.e. number of meetings attended by the independent directors has a significant negative association with earnings management. Literature provides three theories about the effect of multiple directorships of independent directors on their abilities to discharge their functions efficiently on the corporate boards. The “Busyness Hypothesis” argues that too many appointments as directors in board of different companies may restrict the abilities of independent directors to function efficiently. This harms the firm value as it reduces the oversight of management, increases agency cost and causes higher probability of financial statement fraud (Beasley, 1996). Jiraporn, Kim and Davidson (2008) argue that multiple directorships reduce effective monitoring and thus cause reduction in shareholder’s wealth. On the other hand, “Quality Hypothesis” or “Reputation Hypothesis” suggest that multiple directorships represent the experience, expertise and reputation of the independent directors (Ferris et al, 2003, and Fama and Jensen, 1983). Using number of directorships as proxy of independent director’s reputation, Shivdasani (1993) and Vafeas (1999) argue that independent directors with more directorships are better monitors. The “Resource Dependence Hypothesis” suggests that independent directors with
more directorships have more networking resources, which often benefits the firmâ€™s performance. Sarkar and Sarkar (2009) argues that multiple directorships of independent directors is positively related with the firm value. Based on the above literature the below hypothesis are formed for the present study: H1: There is no significant association between board independence and earnings management. H2: There is no significant association between diligence of independent directors and earnings management. H3: There is no significant association between busyness of independent directors and earnings management.
DATA AND METHODOLOGY Data Source The data for this study has been obtained from Prowess database created by Center for Monitoring Indian Economy (CMIE). Prowess is one of the most widely used databases in academic research as well as in industry. Clause 49 of the listing agreement requires every listed company to disclose the following with regard to board of directors in the annual report of the company: 1.
Composition and category of directors for example, promoter, non-promoter, executive, non-executive, independent etc.
Attendance of each director at the board meetings and the last AGM.
Number of other boards in which he or she is a member or chairperson.
Number of board meetings held and date on which held.
The data on financial variables and above stated corporate governance variable was extracted from Prowess for three financial years viz. 2008-09, 2009-10 and 2010-11. Data Sample The sample for this study consists of 200 non- Government owned manufacturing firms listed on National Stock Exchange of India (NSE). There are total 1679 companies listed on NSE out of which 959 belongs to the manufacturing sector. From these 959 companies, I reduce 88 companies in which Central and/or State Government has any shareholding. Further, 44 foreign companies are removed from this data to arrive at a list of 827 companies. This study requires that each industry should have at least 20 companies in order to have a representative sample for computing the discretionary accruals. Using National Industrial Classification (NIC) code at two-digit level, the industries are classified. From the list of 827 companies, I remove 80 companies for which industry does not have a representative sample of 20 companies. From the revised list, those companies are excluded for which either the annual financial data is not available or the annual financial data is not exactly for 12 months due to change in the accounting year. This is done to ensure correct computation of level of discretionary accruals. A final list of 610 companies is thus obtained. These companies are then arranged in the descending order of their turnover and first 200 companies from the arranged list are taken as the sample. Financial and corporate governance data for these 200 companies were extracted from the Prowess database for a period of three years to obtain 600 observations in the sample. From these 600 observations 28 observations are removed due to non-availability of the corporate governance information in the Prowess database to obtain the final sample of 572 firm-years.
Independent Directors and Earnings Management – Evidence from India
Variables The objective of this paper is to study the effect of independent director’s profile on earnings management. There are three broad categories of variable viz. opportunistic earnings management, characteristics of independent directors and control variables. Below are the descriptions of each category of variable. Opportunistic Earnings Management Opportunistic earnings management is the dependent variable in this study. One way to practice earnings management is through the timing of recognition of revenues and expenses. The other way is by exercising the choice of accounting method. In any of these two cases, Generally Accepted Accounting Principles (GAAP) or Accounting Standards would require a disclosure. An alternative way to manage earnings is by exercising discretion over estimates for computation of accruals. This approach is sometimes also called as accruals management. Managers prefer managing earnings through accruals, as they require less disclosure and are generally difficult to detect. Further, this technique not only reflects the choice of accounting method but also the effect of timing of recognition of revenues and expenses and changes in accounting estimates. Opportunistic earnings management in such situation would be reflected by the level of discretionary accruals. Discretionary accruals is the difference between the total accruals and non-discretionary accruals (or non-manipulated accruals). Researchers have always faced problems in bifurcating total accruals between discretionary and nondiscretionary. Healy (1985) and DeAngelo (1986) defines non-discretionary accruals in the event period based on the total accruals in the estimation period. Both studies assume that earnings management takes place only in the event period. Jones (1991) argues that non-discretionary accruals may not remain constant over time and may change due to change in firm’s economic conditions such change in revenues and gross property, plant and equipment. Jones (1991) provides the below regression equation to compute the level of discretionary accruals: TAit/Ai,t-1 = β0(1/Ai,t-1) + β1(∆REVit) /Ai,t-1 + β2(PPEit) /Ai,t-1 + εit
Where, TAit = (∆CAit - ∆CLit - ∆Cashit + ∆STDit – Depit)
∆REVit is the change in revenues for firm ‘i’ in period‘t’. PPEit is gross property, plant and equipments Ai,t-1 is the lagged total assets ∆CAit
is the change in current assets
∆CLit is the change in current liabilities ∆Cashit is the change in cash and cash equivalents ∆STDit is the change in short-term debt Depit is the depreciation. The discretionary accruals are captured by the residual in equation (1) and are a proxy for earnings management. Jones (1991) model was originally introduced as time series. However, many recent studies have applied the regression equation (1) suggested in the model in cross-sectional analysis as well.
Dechow et al (1995) proposed the Modified Jones Model. They argued that managers may manage earnings by recording revenues which remain uncollectible at the year end. Thus, they suggested the below model by adjusting the change in revenues in the Jones model: TAit/Ai,t-1 = β0(1/Ai,t-1) + β1(∆REVit - ∆RECit) /Ai,t-1 + β2(PPEit) /Ai,t-1 + εit
Where, ∆RECit is the change in receivables. Other parameters and variables remain same as the Jones model. Later, Kothari et al (2005) suggested adding the prior performance of the company to reduce the measurement errors of discretionary accruals. They added return on assets (ROA) as an additional regressor in the modified Jones model. Dechow and Dichev (2002) proposed a model based on cash flow measures to assess the accrual quality, which Francis et al (2005) combined with the Jones model. Both Jones model and Modified Jones model have been extensively used in earnings management literature. This study uses the Modified Jones model. For this purpose, the total accruals for firm i in year t using equation (2) were computed in the first step. In the second step, equation (3) was applied to estimate the value of parameters β0, β1 and β2. The parameters are estimated for each year and each industry using cross-sectional data of all manufacturing companies listed on National Stock Exchange (NSE) and classifying industries based on National Industrial Classification (NIC) code at two-digit level. For this study, only those industries were considered which have at least 20 companies to ensure that parameter estimates are representative. In step three, level of discretionary accruals were computed as below: DA = TAit/Ai,t-1 – [β0(1/Ai,t-1) + β1(∆REVit - ∆RECit) /Ai,t-1 + β2(PPEit) /Ai,t-1]
Klein (2002), Haw et al (2004) and Sarkar, Sarkar and Sen (2008) suggest the use of absolute value of discretionary accruals as managers may have motives for both income-increasing as well as income-decreasing earnings management. The same approach is adopted for this study although some secondary analysis was done using signed discretionary accrual as well. Characteristics of Independent Directors Following the study by Sarkar, Sarkar and Sen (2008), the study uses two measures of board independence viz. proportion of independent directors in the board and a dummy variable that takes the value of one if the board has majority of independent directors and zero otherwise. Second variable is the average percentage of board meetings attended by the independent directors. This variable measures how diligent are the independent directors in fulfilling their responsibilities. Another factor to analyze about independent directors is their busyness. As discussed earlier, multiple directorships of an independent director may result in reducing their abilities to function efficiently. On the other hand, it can be argued that multiple directorship results in better directorial quality and thus would help to constrain earnings management. To measure the busyness of independent directors, two variables were used in this study. Following Sarkar, Sarkar and Sen (2008), the first variable is dummy variable, which takes the value of one if an independent director has more than three directorships; otherwise, it takes the value of zero. The second variable is a dummy variable that takes the value of one if an independent director is the chairperson of board in other company; otherwise, it takes the value of zero. Control Variables In order to avoid spurious relation between dependent and independent variables, it is important to include factors that can otherwise influence the dependent variable. Going with earlier studies, which have found that size is negatively
Independent Directors and Earnings Management – Evidence from India
related to earnings management whereas financial leverage is positively related to earnings management, this study uses log of total assets as a proxy for size and total debt to total asset ratio as a proxy of financial leverage. Further, some studies found that big four auditors are more conservative in their approach and hence may reduce the level of earnings management. Therefore, this study uses a dummy variable that takes the value of one if the auditor is big four; otherwise, it takes the value of zero. Last control variable is a dummy variable that takes the value of one if the firm belongs to a corporate group; otherwise, it takes the value of zero. This variable is important considering the unique business environment in India where large business groups dominate. The regression equations include industry dummies to capture the unobserved industry effects. The list of variables and their definitions are summarized in Table 1: Table 1: List of Variables and Their Definitions
Variable Abs_DA Pos_DA Neg_DA Maj_ID P_ID BM_ID LDS_ID CHRM_ID Size FL AUD GRP
Definition Absolute discretionary accruals calculated using Modified Jones Model (1995) Positive discretionary accruals calculated using Modified Jones Model (1995) Negative discretionary accruals calculated using Modified Jones Model (1995) Majority of independent directors on board. Dummy variable that take the value of one if majority is of independent directors otherwise zero Proportion of independent directors on board. Average percentage of board meetings attended by independent directors. Large other directorships of independent director. Dummy variable that take the value of one if independent director has more than 3 other directorships, otherwise zero. Independent director being chairperson in board of other company. Dummy variable that takes the value of one if independent director is also a chairperson in other company, otherwise zero. Log of total assets Financial leverage computed as ratio of total debt to total asset. Auditor being big 4. Dummy variable that take the value of one if auditor is big otherwise zero. Firm belonging to a business group. Dummy variable that takes the value of one if the company belongs to a business group otherwise zero.
The study estimates the effect of independent directors on discretionary accruals by two models. The first model takes percentage of independent directors of board as a proxy for board independence while the second model considers majority of independent directors as a proxy for board independence. Below are the two regression models that this study estimates: Model 1 DA = β0 + β1P_ID + β2BM_ID + β3LDS_ID + β4CHRM_ID + β5Size + β6FL + β7AUD + β8GRP + ε Model 2 DA = β0 + β1Maj_ID + β2BM_ID + β3LDS_ID + β4CHRM_ID + β5Size + β6FL + β7AUD + β8GRP + ε
FINDINGS Descriptive Statistics Descriptive statistics of the sample is produced in Table 2 below. Total sample observations for this study is 572. 46.7% of the total observations have generated positive discretionary accruals and rest 53.3% have generated negative
discretionary accruals. Average level of discretionary accruals, considering absolute value of discretionary accruals is 9.7% of lagged total assets with a median value of 7.4%. This indicates the some of the observations have relatively higher values of discretionary accruals. This finding is similar to Sarkar, Sarkar and Sen (2008). However, the average discretionary accrual for observations generating positive discretionary accruals is more than 11% of lagged total assets compared to 8% reported by Sarkar, Sarkar and Sen (2008). This establishes our conjecture that in tougher times of financial meltdown, firms may indulge in aggressive income-increasing earnings management practices. Mean and median of observations generating negative discretionary accruals is comparable to the levels reported by Sarkar, Sarkar and Sen (2008). Table 2: Descriptive Statistics Variable
50% of the sample companies have majority independent board and mean value of percentage of independent directors on the board stands at 53.4%. 90% of the independent directors of the sample companies have more than 3 other directorships indicating very high busyness of independent directors (Busyness Hypothesis) on one hand and very high reputation and expertise (Quality/Reputation Hypothesis and Resource Dependence Hypothesis) on the other hand. However, only about 7% of the independent directors of the sample companies are chairperson in the boards of other companies. Further, the descriptive statistics suggest that, on an average, independent directors attend 72% of the board meetings. Average size of sample companies, measure by log of total assets, is 4.3, which is almost equal to its median value representing a balanced distribution. The sample companies have average total debt to total asset ratio of 0.56. More than 36% of the sample companies have big four auditors. Further, more than 80% of the sample companies belong to a business group representing a unique feature of Indian business environment. Regression Results Following Sarkar, Sarkar and Sen (2008), the estimate of regression of discretionary accruals is done under two models. In the first model, Model 1, board independence is measured by considering percentage of independent directors on the board. In the second model, majority of independent board is taken as the proxy for board independence. Table 3 provides the results for the two regression models. The results of Model 1 and Model 2 do not suggest any significant association between board independence, measured by proportion of independent directors or majority of independent
Independent Directors and Earnings Management – Evidence from India
directors, and discretionary accruals. These results are similar to Sarkar, Sarkar and Sen (2008). However, the results suggest a significant negative association between the number of directorships in other companies of independent directors and discretionary accruals. This proves the ‘Quality/Reputation Hypothesis’ and the ‘Resource Dependence Hypothesis’ and refutes the ‘Busyness Hypothesis’. Thus, the results of this study suggest that independent directors, who hold large number of directorships in other companies, can substantially reduce the earnings management practices due to their expertise and experience. These results conflicts with Sarkar, Sarkar and Sen (2008). In contrast, the results also suggest a significant positive association between chairmanship in other companies of independent directors and discretionary accruals. Thus the results reveal that having independent directors who are also chairperson in other companies increase the level of discretionary accruals. An additional analysis (not presented here), if the observation where an independent directors is also a chairperson (40 in number) are removed from the sample, suggests that number of directorships of independent directors in other companies still has a significant (p-value 2.8%) negative association with discretionary accruals.
Looking at the combined effect of two factors, viz. independent directors holding directorships in other
companies and independent directors holding the position of chairperson in other companies, it is observed that when independent directors hold directorships other companies but do not hold the position of chairperson the Quality hypothesis and Resource. Dependence Hypothesis are more prominent than the Busyness Hypothesis. Contrary to this, in case the independent director also holds the position of chairperson in other companies, Busyness hypothesis is more prominent than the other two. Further analysis, not presented here, suggests that in 78% of the cases where an independent director is also a chairperson in other companies, he/she is also a director in more than two companies. This further substantiates the busyness hypothesis in such case Table 3: Effect of Independent Directors on Earnings Management Explanatory Variable Intercept
Model 1 0.2694*** (0.0000)
Maj_ID P_ID BM_ID LDS_ID CHRM_ID Size FL Aud Grp Industry Dummies No. of Observations R2 Adj. R2 F Sig. of F Note: P-value in parenthesis
-0.0046 (0.8931) -0.0290 (0.2266) -0.0436*** (0.0012) 0.0294** (0.0454) -0.0081 (0.4417) -0.0075 (0.3170) -0.0040 (0.6245) -0.0348*** (0.0012) Included 572 0.116 0.083 3.599 0.000
Model 2 0.2683*** (0.0000) -0.0020 (0.7957)
-0.0296 (0.2169) -0.0437*** (0.0012) 0.0294** (0.0452) -0.0080 (0.4458) -0.0075 (0.3153) -0.0041 (0.6190) -0.0349*** (0.0011) Included 572 0.116 0.084 3.602 0.000
***, ** indicate that coefficient is significant at the 1 percent and 5 percent level respectively. In contrast to Sarkar, Sarkar and Sen (2008), this study does not find any significant association between the number of meetings attended by the independent directors and discretionary accruals. However, in a further analysis (not presented here), if signed discretionary accruals are considered in regression equation instead of absolute value of discretionary accruals, the results suggest a significant (p-value 4.3%) negative relation with number of meetings attended by the independent directors. This suggests that although number of meeting attended by independent directors does not constrain opportunistic earnings management, measured by absolute discretionary accruals, but they do adopt a conservative view for reporting earnings.
CONCLUSIONS This study examines the role of independent directors in constraining earnings management practices in India. The main objective of having independent directors on the board is to reduce the agency problem and increase transparency in financial and other reports presented to the body of shareholders. Agency problem generally forms the basis of opportunistic earnings management practices. Hence, analyzing the effect of independent directors on opportunistic earnings management also, to an extent, shows how efficiently independent directors function with the objective of reducing the agency conflict. This paper studies different attributes of independent directors viz. board independence, independent directorâ€™s diligence, and busyness and quality of independent directors. The study uses a sample of 200 companies over a period of three years and computes discretionary accruals as a proxy of opportunistic earnings management. The results of the study shows having very busy independent directors (independent directors who also occupy the position of chairperson in board of other companies and many times also holding other directorships) on board increases the earnings management. However, directorships in other companies of independent directors, without holding the position of chairperson, significantly reduce the opportunistic earnings management. The study did not find any significant relation between board independence and level of earnings management. Thus, the results of this study suggests that it is not independence of board but quality of independent directors and their busyness that plays a role in constraining earnings management. This study adds, in general, to the existing literature on earnings management and stresses on the role of independent directors in constraining earnings management.
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