Board of Director Effectiveness and Earnings Conservatism: Preliminary Australian Analysis
Abstract:
The study’s overarching objective is to examine influence of board of director effectiveness on the extent of earnings conservatism amongst Australian listed firms. The study collected data from a sample of 100 Australian publicly listed firms stratified-randomly selected based on market capitalization to reduce size-biases. Data is collected for the 2008 financial year. Empirical results indicate more effective board of directors a more likely to incorporate negative news into earnings significantly faster (i.e., more timely) than less effective board of directors. This implies firms with more effective board of directors are more likely to report more reliable accounting information than firms with less effective board of directors. Additional analysis also shows that board of directors that are more independent, have independent members who are financially qualified and meet more frequently were more likely to be associated with disclosure of negative news in a more timely manner. However, results show board of directors composed of at least one independent director with prior committee experience were just as likely to report negative news in a similar time frame as board of directors without such experienced members.
1. Introduction and background
Conservatism is one of the principal foundations of financial accounting with a longstanding and substantial influence.[1] Empirical research indicates that conservatism has increased in the past three decades (Balkrishna, Coulton, and Taylor, 2007; Givoly and Hayn, 2002; Givoly and Hayn, 2000; Huijgen and Lubberink, 2005; Krishnan and Visvanathan, 2007a). Despite the longevity and reputed importance of conservatism, capital market regulators, accounting standard-setters and scholars frequently criticize conservatism.[2] The lengthy survival and resilience to criticism, nonetheless, strongly suggests conservatism has significant benefits overlooked by critics.
Whilst there is a need to determine and understand the benefits of conservatism, there is also a significant need to identify factors influencing conservatism. Identifying determinants of conservatism is essential because though capital market regulators and accounting standard-setters may not directly seek to eliminate conservatism, actions affecting the determinants of conservatism could have serious indirect repercussions on financial reporting quality. The need to understand determinants of conservatism has been amplified in the past decade following major corporate financial accounting scandals. It has long been acknowledged corporate management have strong incentives to overstate earnings (Fama, 1980; Jensen and Meckling, 1976). However, escalating pressures during the past decade to meet investor and market expectations for higher revenues and earnings is thought to be increasingly enticing corporate management to adopt more aggressive financial accounting practices. Consequently, this undermines conservatism and the quality of earnings (LaFond and Watts, 2008).
A majority of prior research examining determinants of conservatism has concentrated on the influence of institutional factors (Ball, Kothari, and Robin, 2000; Grambovas, Giner, and Christodoulou, 2006; Lara, Osma, and Mora, 2005). Mounting attention to corporate governance issues in the past decade has spurned a new stream of investigation examining the impact of corporate governance mechanisms on conservatism. To date, much attention in this new stream has concentrated on ownership structure, the auditing process, and audit firms and fees (Ahmed and Duellman, 2007; Beekes, Pope, and Young, 2004; Hamilton, Ruddock, Stokes, and Taylor, 2005; Lafond and Roychowdhury, 2008; Ruddock, Taylor, and Taylor, 2006). Other key corporate governance mechanisms, pivotal to the financial accounting process, however, may likely be of significance but as yet have received little, if any, attention. The board of directors is one such feature.
Board of directors have been placed at the centre stage of the global debate on corporate governance reforms since the early 1990s (Blue Ribbon Committee, 1999; Corporate Governance Committee, 2001; New York Stock Exchange and National Association of Securities Dealers, 1999). Whilst boards of directors are acknowledged as the ultimate corporate governance mechanism for monitoring the financial reporting process, responsibility for the general and day-to-day oversight is increasingly delegated to the board of directors. The introduction of new corporate governance regulations such as the ASX Corporate Governance Council Recommendations (ASX 2003) and the Corporations Law Economic Reform Programme 9 (CLERP 9) have served to increase the responsibilities and influence of board of directors in the financial reporting process.
Given the unprecedented and ever increasing interest in earnings by investors, combined with escalating demands for higher quality earnings, there is an urgent need to identify influential factors and the resulting impact on earnings. As discussed above, both the conservatism principle and the board of directors are alleged to have a significant bearing on earnings (Beasley and Salterio, 2001; Klein, 2002a; Watts, 2003). Currently the influence of a board of directors and its effectiveness on conservatism (and ultimately earnings quality) remains an open empirical question that has not been formally investigated. A pivotal aim of this study is to address this void in the extant literature surrounding conservatism and the board of directors.
Studying board of director effectiveness/earnings conservatism linkage is important and timely. Presently, international capital markets (including Australia) are highly volatile, raising questions about earnings quality. Understanding the board of director effectiveness/earnings conservatism link, and the impact on earnings quality, assists regulators derive strategies to restore credibility in earnings. More generically, corporate governance is continuously under reform. Studying the earnings conservatism/board of director effectiveness linkage, therefore, is of value as results will determine whether there is a likelihood any changes to regulations governing board of directors will impact on conservatism and earnings quality. Considering the earnings conservatism/board of director effectiveness linkage in the context of Australia is also of interest. For example, corporate governance has been a hot-bed of debate with the introduction of regulations such as ASX 2003 and CLERP 9. The effectiveness and impact of these corporate governance reforms is still a matter of debate. Findings from this study will aid in shedding new light and understanding on the debate. Also, the study focuses on Australia because of the (a) paucity of existing research examining the relationship between board of directors and financial reporting quality in Australia, and (b) mixed empirical results to date using data from this nation (Francis and Stokes, 1986; Goodwin, 2003; Stewart and Munro, 2007).
The primary objective of this study is to examine the association between board of director effectiveness and earnings conservatism of Australian publicly listed firms. There is currently a lack of consensus in the extant literature of a precise definition or factors determining board of director effectiveness. Corporate governance advocates generally argue structural and operational composition factors influence a board of director’s effectiveness. For example, in respect to structural composition, Klein (2002a) argues more independent board of directors are effective in constraining managerial opportunism, thereby, leading to greater quality of reported earnings. In the case of operational composition, Abbott and Parker (2000a) and Abbott et al., (2003) state more diligent board of directors (i.e., meet more frequently) are better able to address key financial reporting issues such as earnings management and financial misstatement. In line with prior literature (Beasley and Salterio, 2001; Van der Zahn and Tower, 2004) this study focuses on four prime components underlying board of director effectiveness: (a) sub-committee independence; (b) financial expertise; (c) experience; and (d) diligence.
Overall, this study will benefit 1) firms in determining the optimal composition of board of directors, 2) policymakers and investors by identifying the impact of board of director features; and 3) regulators in determining the true role board of directors play in improving the level of earnings quality reported by firms and therefore, the integrity of the financial reporting process. Finally, findings from this study can be the basis of a more structured and systematic approach to board of director formation and the ability of the board of director to uphold key regulatory reforms.
2. Literature Review and Hypotheses Development
Scholars have a lengthy history of supporting the importance of board of directors to the financial accounting process including influencing earnings quality (e.g., Beasley and Salterio, 2001; Pincus, Rusbarsky, and Wong, 1989). It is argued the central role of the board of director is to reduce the magnitude of positive or negative abnormal accruals, thereby, enhancing earnings quality. The board of director’s ability to accomplish any required and/or perceived roles and responsibilities in monitoring the financial reporting process will depend primarily upon the sub-committee’s effectiveness. Despite extensive debate there is little empirical research surrounding the issue of a board of director’s effectiveness. Aside from studies focusing on earnings management, very few empirical studies have sought to determine the influence of board of director effectiveness on other aspects of financial accounting such as conservatism.
The conservatism concept is an effective governance mechanism. Watts (2003), for example, suggests that the use of conservative accounting figures in contractual arrangements amongst various parties associated with the firm reduces information asymmetry and moral hazard problems derived from agency conflicts. A growing number of researchers (Ahmed and Duellman, 2007; Beekes et al., 2004; Lara et al., 2005) argue other corporate governance mechanisms may provide an additional layer of conservatism important in determining earnings quality. Actions by regulators affecting corporate governance mechanisms, therefore, could inadvertently affect conservatism and earnings quality.
2.1 Theoretical Perspective
Since Jensen and Meckling’s (1976) seminal work developing a theory of the firm based on conflicts between contracting parties, a vast body of literature has developed explaining the nature of the conflicts and means by which conflicts may be resolved. This theoretical perspective, commonly known as agency theory, is strongly linked to earnings conservatism and board of directors’ role and responsibilities. Watts (1992), for example, suggests conservatism likely evolved from accounting’s contracting role. Watts (1992) argues accounting conservatism helps avoid inappropriate distributions to claim holders. Basu (1997) suggests the conservatism principle evolved with audited financial statements as a means of management bonding that prevents management exploiting information asymmetry (a premise of Fama's 1980, agency theory). Ahmed et al., (2002) support the conservatism and contractual arrangements link (and, in turn, agency theory). Specifically, Ahmed et al.,(2002) argue conservatism mitigates conflicts of interest over dividend policy between shareholders and bondholders. Finally, Watts (2003) expresses the view earnings conservatism is a component of efficient contracting that restricts management’s opportunistic behaviour in contracting purposes. In the case of board of directors, agency theorists strongly argue the board of directors is a pivotal governance mechanism to mitigate conflicts between contractual parties. Carcello and Neal (2000), for example, suggest a board of directors plays an important monitoring role. Beasley (1996), for example, argues a board of directors is an effective monitoring mechanism in assuring the quality of financial reporting and corporate accountability. This view is supported by others such as Carcello and Neal (2000), Klein (2002a) and Van der Zahn and Tower (2004). Given the close association of conservatism and board of directorss to contractual arrangements and agency conflicts, agency theory provides the study’s underlying theoretical perspective.
2.2 Earnings Conservatism
Various renowned scholars (Ball and Shivakumar, 2005; Francis, LaFond, Olsson, and Schipper, 2005; Watts, 2003) consider earnings conservatism a central indicator of earnings quality or a desirable property of accounting earnings. Therefore, studies have examined the different aspects of conservatism including existence, time series pattern, and determinants of conservatism (Basu, 1995; 1997; Givoly and Hayn, 2000; Lubberink and Huijgen, 2001; Givoly and Hayn, 2002; Penman and Zhang, 2002; Lobo and Zhou, 2006; Ruddock et al., 2006; Givoly et al., 2007; Krishnan, 2007; Krishnan and Visvanathan, 2007a; Roychowdhury and Watts, 2007).
The existence of earnings conservatism is strongly supported by the seminal study by Basu (1997). After the groundbreaking findings of Basu (1997), Pae, Thornton and Welker (2005) found that earnings were conservative in all periods examined. Similarly, Balkrishna, Coulton and Taylor (2007b) sought to provide evidence of earnings conservatism in the financial reporting practices of Australian firms. Apart from providing evidence about the existence of earnings conservatism, some studies (Basu, 1997; Givoly and Hayn, 2000; Givoly and Hayn, 2002; Huijgen and Lubberink, 2005; Lobo and Zhou, 2006; Balkrishna, Coulton and Taylor, 2007a; Krishnan, 2007) sought to examine the time-series pattern of earnings conservatism and concluded that earnings conservatism has increased over time (Basu, 1997; Givoly and Hayn, 2000; Givoly and Hayn, 2002; Huijgen and Lubberink, 2005; Lobo and Zhou, 2006; Balkrishna et al., 2007a; Krishnan, 2007).
Prior research on earnings conservatism has also identified a number of determinants which influence earnings conservatism (Ball et al., 2000a; Gigler and Hemmer, 2001; Easton and Pae, 2004; Gassen et al., 2006a; O'Connell, 2006; Qiang, 2007a; Lafond and Roychowdhury, 2008). The determinants can be classified into three broad categories: (1) firm characteristics (2) institutional factors and (3) governance structures.
In relation to firm characteristics, Easton and Pae (2004) found evidence that change in cash investment provided significant incremental explanatory power for returns over earnings and earnings changes. Similarly, Pae et al. (2005) showed that earnings conservatism was substantially greater in portfolios of firms with lower price-to-book ratios than in portfolios of firms with higher price-to-book ratios. Kwon, Yin and Han (2006), further indicated that distribution of earnings and discretionary accruals between the two groups of firms were consistent with a higher level of accounting conservatism evident in high-tech firms vis-à-vis low-tech firms. In addition, Pae (2007) found that conditional accounting conservatism was attributable mainly to unexpected accruals suggesting that managers exercise discretion over accruals to expedite the recognition of bad news rather than good news.
Prior research has concluded that institutional factors such as accounting polices and regulation, legal regimes (i.e. code law versus common law), political influence and cross-listing of firms in different jurisdictions have a significant impact on the level of earnings conservatism reported by firms (Pope and Walker, 1999; Huijgen and Lubberink, 2005; Lara et al., 2005; Brown Jr. et al., 2006; Bushman and Piotroski, 2006). Ball, Kothari and Robin’s (2000b) results indicated that common-law accounting income did exhibit greater timeliness than code-law accounting income. Pope and Walker (1999), for example, concluded that the US accounting regime was significantly more conservative than the UK regime, when comparing earnings before extraordinary items. Similarly, Huijgen and Lubberink (2005) found that earnings of UK cross-listed firms (in the US) were significantly more conservative than earnings of UK firms without a US listing. In addition, Lara et al. (2005) reported that in certain institutional contexts (that is, weaker investor protection and less dispersed ownership structures), earnings management drove the measures of conservatism. Finally, Bushman and Piotroski (2006) found that investor protections embodied in corporate law and the efficiency and impartiality of the judicial system played a significant role in creating incentives for timely loss recognition.