An exploratory study of the effects of the European Union 8th Directive on Company Law on audit committees: Evidence from EU companies listed on the US stock exchanges

Advances in Accounting, incorporating Advances in International Accounting 24 (2008) 262–271

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Advances in Accounting, incorporating Advances in International Accounting j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / a d i a c

An exploratory study of the effects of the European Union 8th Directive on Company Law on audit committees: Evidence from EU companies listed on the US stock exchanges Louis Braiotta Jr. 1, Jian Zhou ⁎ School of Management State University of New York at Binghamton PO Box 6000 Binghamton, NY 13902-6000 USA

a b s t r a c t Member States in the European Union will be required to establish audit committees for all public-interest entities, according to the EU 8th Directive on Company Law. This EU 8th Directive creates a convergence of corporate oversight for both audit processes and financial reporting process and thus provides an opportunity to examine and contrast associations that exist among audit committee, board of directors characteristics with audit committee alignment, and the impact of such alignment on earnings management. Results of a logistic regression analysis suggest that firms with audit committees possessing greater financial expertise, with larger boards and more independent boards are less likely to engage in audit committee alignment while firms with audit committees possessing greater governance expertise are more likely to engage in alignment. In addition, we find that firms associated with audit committee alignment engage in less earnings management. © 2008 Elsevier Ltd. All rights reserved.

1. Introduction In recent years, a number of major accounting scandals in the United States (e.g., Enron and WorldCom) and in the European Union (e.g., Parmalat and Ahold) as well as the demise of Andersen LLP, have shaken the global capital markets. While Congressional legislation (Sarbanes–Oxley Act of 2002) and corporate governance reform (SEC and SROs initiatives) were enacted in the U.S., the Commission of the European Communities issued a proposal in 2004 and its final directive in 2006 which broadens the scope of the former EU 8th Directive on Company Law with respect to mandated audit committees for public-interest entities and other changes in corporate governance and statutory audits.2 The proposal was finalized and approved on May 17, 2006 and became effective immediately. In contrast to the Sarbanes–Oxley Act of 2002 for US firms (SEC Form 10K filers), the EU 8th Directive provides similar legislative reforms which are designed to restore investor confidence in the European capital markets (see Appendix Part A for institutional background information and Appendix Part B for a comparison between the EU 8th Directive and Sarbanes–Oxley Act of 2002).3

⁎ Corresponding author. Tel.: +1 607 777 6067; fax: +1 607 777 4422. E-mail addresses: [email protected] (L. Braiotta), [email protected] (J. Zhou). 1 Tel.: +1 607 777 6859; fax: +1 607 777 4422. 2 SRO means Self Regulatory Organization such as NYSE and NASDAQ (SEC 2003a,b). 3 The single European capital market has 7000 listed firms subject to annual statutory audits. 0882-6110/$ – see front matter © 2008 Elsevier Ltd. All rights reserved. doi:10.1016/j.adiac.2008.09.001

This study examines audit committee and board characteristics associated with audit committee alignment influenced by the EU 8th Directive. Additionally, this paper examines the impact of audit committee alignment on firms' earnings management. The EU 8th Directive allows a cross-sectional empirical examination of the relation between board and audit committee characteristics and audit committee alignment. In this study, audit committee alignment is defined as a process, affected by the firm's board of directors, designed to implement changes (reforms) in the firm's audit committee structure and composition to meet regulatory requirements. More specifically, audit committee alignment occurs if a firm changes its audit committee size and/or changes its audit committee composition to satisfy regulatory requirements.4 This study empirically examines the differences in the structure and composition of boards of directors and audit committees for firms with and without audit committee alignment based on disclosures provided in the 2002–2004 SEC Form 20-F filings of a sample of 309 EU firm year observations listed on the US stock exchanges. We investigate the 2002–2004 to provide an investigation of voluntary compliance of the EU 8th Directive. We focus on EU firms listed on US 4 For example, a firm has experienced audit committee alignment if the firm changes the number of members sitting on the audit committee to satisfy the regulatory requirements. A firm also has audit committee alignment if the firm replaces its audit committee members without changing the number of audit committee members to satisfy the regulatory requirements. Alignment is set to 1 if a firm changes the number of audit committee members or replaces an audit committee member with another member to satisfy the regulatory requirement, 0 otherwise.

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stock exchanges due to governance data availability since all the governance data needs to be hand-collected from the SEC filings. We find that firms with audit committees possessing greater financial expertise, with larger boards and more independent boards are less likely to engage in audit committee alignment while firms with audit committees possessing greater governance expertise are more likely to engage in alignment. In addition, we find that firms associated with audit committee alignment engage in less earnings management. This study is important because of the impact of the EU 8th Directive on audit committees including the convergence of corporate oversight for the audit processes and financial reporting process. Likewise, investors should be afforded oversight protection with respect to a reliable financial reporting process as well as an efficient global securities marketplace. Recent and continued initiatives to develop harmonized international accounting and auditing standards reinforce the need to achieve uniformity in corporate oversight protection to investors. This paper contributes to the extant literature by estimating the requirements of the EU 8th Directive for audit committees and testing the board and audit committee characteristics associated with audit committee alignment and the impact of audit committee alignment on earnings management. We also document that audit committee alignment is associated with less earnings management. 2. Related research and hypotheses development Prior research has examined audit committees drawing upon the concepts from legal theory and agency theory in the context of enhanced corporate governance. For example, American Bar Association (1994), American Law Institute (1994), and Braiotta (1998) argue that: Establishment of audit committees is in response to the investing public's increased demand for corporate accountability through effective oversight of both the audit processes and financial reporting process. This stream of legal research has recognized that boards of directors through their audit committees can effectively discharge their legal fiduciary responsibilities to the stockholders. To the extent that audit committees help boards discharge their financial and fiduciary responsibilities, shareholders and potential investors are afforded a reliable financial reporting system which, in turn, helps to ensure an efficient global securities marketplace. Thus, because boards and their standing committees have a statutory duty of care and loyalty in their fiduciary capacity with the corporation, the investing public is afforded oversight protection which helps minimize a high risk premium for price protection. Moreover, the fiduciary responsibility of boards of directors is well established in many countries. The wide acceptance of the fiduciary principle and the board's stewardship accountability to shareholders serves as a normative model of corporate oversight protection for investors. Cook (1993, 43) notes: These committees add considerable value to the quality and credibility of our financial reporting process. Their oversight of auditing functions and of a company's internal control system helps to protect shareholder interests by keeping business on the straight and narrow. Jensen and Meckling (1976) provide a descriptive theory of agency costs produced by the inherent conflict of interests between owners (principals) and management (agents). Watts (1977) and Leftwich, Watts and Zimmerman (1981) present evidence that the quality of external reporting and related auditing process can reduce agency costs. Pincus, Rusbarsky and Wong (1989) and Collier (1993) investigated the voluntary formation of audit committees using agency theory and found that firms with high agency costs will voluntarily form audit committees to ensure the quality of audit processes and financial reporting disclosures. This stream of research suggests that as the number of stockholders increases, the motivation

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to establish audit committees increases because of the risk of greater conflicts of interest between principals and agents. These arguments suggest that the formation of audit committees is responsive to the investing public's demand for oversight protection. 3. Audit committee characteristics and audit committee alignment An audit committee plays an important monitoring role in assuring the quality of financial reporting and corporate accountability, and the audit committee composition is an important factor in effective monitoring (Beasley, 1996; Carcello & Neal, 2000). Audit committee composition has been the focus of many governance reform efforts, and all companies listed in major stock exchanges such as NYSE, NASDAQ, and AMEX must now maintain an audit committee with at least three independent directors (e.g., Sommer, 1978; Vicknair, Hickman & Carnes, 1993; Wild, 1996; BRC, 1999; SEC, 1999). Pincus et al. (1989) suggest that audit committees are an expensive monitoring mechanism and that firms with larger audit committees are willing to spend more resources on this important mechanism and are likely to improve the function of audit committees. Anderson, Mansi, and Reeb (2004) find that the larger the audit committee, the lower the cost of debt financing. Chen and Zhou (2007) find that firms with larger audit committees choose higher quality successive auditors during Andersen's demise. All these literature suggests that larger audit committees are likely to be a more effective mechanism. Therefore, this study uses audit committee size to examine its association with audit committee alignment, and argues that audit committees with more members are less likely to engage in costly audit committee alignment given that such committee already satisfies regulatory requirement. Jemison and Oakley (1983, 519) argue that an active audit committee, totally composed of outside directors, is a key element of effective corporate governance. Carcello and Neal (2003) find that audit committees with greater independence are less likely to dismiss the auditors following the issuance of new going-concern reports. Abbott, Parker and Peters (2004) document a significant negative association between the audit committee independence and the financial restatements. Klein (2002b) finds there is a negative relation between audit committee independence and abnormal accruals. Therefore we expect that more independent audit committees are less likely to go through costly alignment. The Blue Ribbon Committee's (BRC) expertise recommendation requires that audit committee must have at least one financially literate member.5 Audit committee members with financial expertise can perform their oversight roles of financial reporting process more effectively, such as in internal controls or detecting material misstatements (Raghunandan, Read & Rama, 2001; Scarbrough, Rama & Raghunandan, 1998). Bédard, Chtourou and Courtean (2004) find that the presence of at least one financial expert on the audit committee is associated with a lower likelihood of aggressive earnings management. DeFond, Hann and Hu (2005) find significantly positive cumulative abnormal returns around the appointment of accounting financial experts to the audit committee, suggesting that audit committees with accounting financial expertise improve corporate governance. We expect that audit committees with at least one financial expert are less likely to engage in audit committee alignment since they already have a financial expert on the audit committee. 5 The Report of the BRC's recommendation related to Audit Committee Competence states that “the audit committee should consist of at least three members, each of whom is “independent” (defined in the Report as having “no relationship to the corporation that may interfere with the exercise of their independence from management and the corporation”) and “financially literate” (defined as “the ability to read and understand fundamental financial statements”). At least one member of the audit committee should have accounting or financial management expertise (defined as past employment or professional certification in accounting or finance, or comparable experience including service as a corporate officer with financial oversight responsibility)”.

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DeZoort and Salterio (2001) find that audit committee members with corporate governance experience and financial reporting and auditing knowledge are more likely to understand auditor judgments and to support the auditor in auditor-management disputes and are more likely to address and detect material misstatements. By using a matched-pairs sample on opinion, year, size, and industry, Carcello and Neal (2003) find that audit committees with greater governance expertise are more effective in shielding auditors from dismissal after the issuance of new going-concern reports. Therefore, we expect that audit committees with greater governance expertise are less likely to engage in audit committee alignment since they already have good governance expertise on the audit committee. In summary, previous literature finds that audit committee size, independence, financial, and governance expertise are important factors affecting the effectiveness of audit committees. Therefore, we propose and test the following hypotheses: Hypothesis 1a. Firms already associated with better audit committee mechanisms (larger, more independent audit committees as well as audit committees with financial and governance experience) are less likely to engage in costly audit committee alignment. 4. Board of directors and audit committee alignment Board of directors performs an important monitoring function for shareholders to ensure reliable and complete financial reporting. According to agency theory, the separation of ownership and control leads to the divergence in the pursuit of managerial interests versus owners' interests (Jensen & Meckling, 1976), and thus monitoring managerial decisions becomes essential for board of directors to assure that shareholders' interests are protected (Fama & Jensen, 1983). Prior studies have used board size to proxy for directors' expertise (Herman, 1981). Jensen (1993) suggested that board size is a valuerelevant attribute of corporate board. It is argued that larger boards will have directors with more diverse educational and technical backgrounds and skills to have multiple perspectives to improve the quality of the firm's decision-making. Larger boards are more likely to present shareholders' interests and are less susceptible to CEO domination by actively monitoring and evaluating CEO. Zahra and Pearce (1989) argue that board composition is pivotal in enhancing the performance of the board's control role. When the board size is large, board committees could help to improve effectiveness of the board's monitoring role.6 Consistent with this line of argument, Anderson et al. (2004) find that the cost of debt is inversely related to board size. Furthermore, as the audit committee is a sub-committee of the full board, its composition depends on the board's structure. For example, Klein (2002a) finds that board size is positively related to audit committee independence. This suggests that companies with larger boards are able to form and maintain independent and effective sub-committees. Accordingly, we use the number of board members to proxy for the necessary expertise and manpower to form an effective audit committee, and we argue that firms already associated with larger boards are less likely to engage in audit committee alignment given the evidence in Klein (2002a). Prior studies confirm the role of outside directors in the governance of public companies (Beasley, 1996; Pincus et al., 1989). Beasley and Petroni (2001) find that boards with higher percentage of outside directors are more likely to select a specialist Big 6 auditor. Anderson et al. (2004, 329) find that the correlation between board independence and audit committee independence is 0.60. Since firms with more independent boards are more likely to have a more

6

However, there is also empirical evidence showing that smaller boards are more likely to have better monitoring quality because agency problems (e.g., free-riding problems among directors and process losses) increase with board size (Yermack, 1996; Hermalin & Weisbach, 1998, 2003).

independent audit committee, we propose that such firms are less likely to have audit committee alignment. In summary, board size and independence level all influence the effectiveness of a board, which in turn is related to the effectiveness of an audit committee. Therefore, we propose the following hypotheses: Hypothesis 1b. Firms already associated with a larger and more independent board are less likely to engage in audit committee alignment. Recent research suggests that the size, composition and level of independence of both the audit committee increase their monitoring effectiveness of such matters as earnings management, audit adjustments, and fraud risk assessment (Kalbers and Fogarty, 1993; Klein, 1998; Beasley, Carcello, Hermanson and Lapidies, 2000; Carcello and Neal, 2000; Beasley and Salterio, 2001; Klein, 2002a; Klein, 2002b; DeZoort, Hermanson and Houston, 2003; Abbott et al., 2004; Braiotta, 2004). For example, Klein (2002b) argues that a reduction in the audit committee independence increases abnormal accruals. Carcello and Neal (2000) find that the greater the percentage of affiliated directors on the audit committee, the lower the probability the auditor will issue a going-concern report. Likewise, Carcello and Neal (2003) find that the higher the percentage of affiliated directors on the audit committee, the more likely a client will dismiss its independent auditors because of a going-concern audit report. Firms which experience audit committee alignment to improve audit committee size, independence, financial and governance expertise are likely to engage in less earnings management since the improved audit committee will object to such earnings management behavior. So we propose the following: Hypothesis 2. Firms with audit committee alignment engage in less earnings management since alignment improves the effectiveness of the audit committee. 5. Research design 5.1. Testing determinants of audit committee alignment We use the following logit regression Model 1 to test Hypotheses 1a and 1b: ALIGNit ¼ b0 þ b1 ACSZLGit−1 þ b2 ACINDLGit−1 þ b3 FINEXPLGit−1 þ b4 GOVEXPLGit−1 þ b5 BDSZLGit−1 þ b6 BDINDLGit−1 þ b7 SIZEit þ b8 LEVit þ
it where:

ð1Þ

ALIGN = 1 if there is audit committee alignment; 0 otherwise7 ACSZLG = the size of audit committee in the prior year ACINDLG = the percentage of independent member on the audit committee in the prior year FINEXPLG = number audit committee members with financial expertise GOVEXPLG = average number of directorship in other public companies held by audit committee members8 BDSIZELG = the prior year's board size, measured as number of board members BDINDLG = percentage of independent directors in the prior year SIZE = log of total sales

LEV = leverage, measured as the ratio of long-term debt to total assets. The dependent variable is ALIGN, defined as 1 if there is audit committee alignment, 0 otherwise. Hypothesis 1a predicts that firms 7 Alignment is set to 1 if a firm changes the number of audit committee members or replaces an audit committee member with another member to satisfy the regulatory requirement, 0 otherwise. 8 This definition of governance expertise is consistent with that in Carcello and Neal (2003).

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already associated with better audit committee mechanisms (larger, more independent audit committees as well as audit committees with financial and governance experience) are less likely to engage in costly audit committee alignment. So we expect that the coefficients b1 to b4 on lagged audit committee size, independence, financial expertise and governance expertise will be negative. We used lagged variables in Model 1 to distinguish between whether a larger, more independent audit committee and boards as well as an audit committee with greater financial and governance expertise leads to audit committee alignment. Hypothesis 1b predicts that firms already associated with a larger and more independent board are less likely to engage in audit committee alignment. So we expect that the coefficients b5 to b6 on lagged board size and board independence will be negative. We also control for firm size and leverage. Larger firms face more public scrutiny from analysts and investors (Lobo & Zhou, 2005). Thus, larger firms gain from the enhanced public image and benefit of having an audit committee alignment. Leverage is defined as long-term debt over total assets. Creditors may require firms to maintain an effective audit committee to ensure the quality of financial reporting since debt covenants are usually based on accounting numbers. As a sensitivity check, we re-estimate Model 1 using contemporaneous measures of audit committee and board variables to obtain the following logit regression Model 2: ALIGNit ¼ b0 þ b1 ACSZit þ b2 ACINDit þ b3 FINEXPit þ b4 GOVEXPit þ b5 BDSZit þ b6 BDINDLGit þ b7 SIZEit þ b8 LEVit þ
it where:

ð2Þ

ACSZ = the size of audit committee in the current year ACIND = the percentage of independent member on the audit committee in the current year FINEXP = number audit committee members with financial expertise in the current year GOVEXP = average number of directorship in other public companies held by audit committee members in the current year BDSZ = the current year's board size, measured as number of board members BDIND = percentage of independent directors in the current year.

5.2. Testing impact of audit committee alignment We use the following regression Model 3 to test Hypothesis 2: DTACCit ¼ b0 þ b1 ALIGNit þ b2 BIG4it þ b3 SIZEit þ b4 OCFTALGit þ b5 INCCHGit þ b6 LOSSit þ b7 LEVit þ b8 SHRDECRit þ b9 SHRINCRit þ
it where:

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BIG4 = 1 if the firm is audited by a Big 4 auditor and 0 otherwise SIZE = log of total sales OCFTALG = operating cash flow deflated by beginning total assets INCCHG = 1 if a firm reports an increase in income compared to last year, 0 otherwise LOSS = 1 if a firm reports a loss this year, 0 otherwise LEV = leverage, measured as long-term debt/total assets SHRDECR = 1 if the firm has a decline of more than 10% of total outstanding shares during the year and 0 otherwise SHRINCR = 1 if the firm has an increase of more than 10% of total outstanding shares during the year and 0 otherwise. This model relates earnings management to the presence of audit committee alignment and several control variables. Hypothesis 2 predicts that firms with audit committee alignment engage in less earnings management since alignment improves the effectiveness of the audit committee; therefore, we expect b1, the coefficient on ALIGN, to be negative. Prior research (e.g., Becker, DeFond, Jiambalvo & Subramanyam, 1998) suggests that Big 4 audit firms restrain managers' ability to exercise accounting discretion. We include the variable BIG4 to control for the effect of auditor quality on the extent of management's discretion over earnings and expect its coefficient to be negative. We also control for firm size since firms of different size may have different incentives and ability to manage earnings. Firms with strong operating cash flow performance are less likely to employ discretionary accruals to boost earnings because these firms are already performing well. Similar to Becker et al. (1998), we include OCFTALG1 to control for this effect and expect its coefficient to be negative. To account for managers' incentives to avoid earnings decreases, we include an income change indicator INCCHG, which takes the value of 1 if firm reports an increase in income. Consistent with Burgstahler and Dichev (1997), we expect the coefficient on INCCHG to be positive. Additionally, we include an indicator variable LOSS if a firm reports a loss. Loss firms may have incentives to engage in income increasing to report a profit. Alternatively they may have incentives to engage in bath-taking behavior to save income for the future. So we make no sign prediction for the coefficient of LOSS. We also control for leverage. DeFond and Jiambalvo (1994) report that managers use discretionary accruals to satisfy debt covenant requirements. Because more highly leveraged firms have greater incentives to increase earnings, we expect the coefficient on the control variable leverage (LEV) to be positive. Prior studies report that desired access to the capital market such as seasoned equity offerings provides managers with an incentive to interfere with reported earnings numbers

ð3Þ 9

DTACC = modified Jones model discretionary accruals

ALIGN = 1 if there is audit committee alignment; 0 otherwise Table 1 Audit committee alignment of sample firms across years and stock exchanges Panel A: audit committee alignment of sample firms across years Year 9

We estimate this model each year for each two-digit SIC industry using the following regression model (each two-digit SIC industry should have at least six observations): TACCit =TAit−1 ¼ α 1 ð1=TAit−1 Þ þ α 2 ðΔREV it −ΔREC it Þ=TAit−1 þ α 3 PPEit =TAit−1 þ
it

where: TACC = total accruals, computed as (net income−cash flow from operation) TA=lagged total assets (data6) ΔREV=change in revenue (data12) PPE=gross property, plant and equipment (data7) ΔREC=change in receivables (data2). The estimates of α1, α2, and α3 obtained from these regressions are then used to estimate discretionary accruals as follows: 
 DACCit ¼ TACCit − ˆa1 1=Ai;t−1 þ ˆa2 ðΔREV it −ΔREC it Þ þ ˆa3 PPEit :

2002 2003 2004 Total

With alignment

Without alignment

Total

Number

%

Number

%

Number

%

31 64 36 131

28.18 52.03 47.37 42.39

79 59 40 178

71.82 47.97 52.63 57.61

110 123 76 309

35.60 39.81 24.60 100.00

Panel B: audit committee alignment of sample firms across stock exchanges Stock exchange With alignment Number NYSE 74 NASDAQ 44 Other exchanges 13 Total 131

Without alignment

Total

%

Number

%

Number

%

43.53 40.37 43.33 42.39

96 65 17 178

56.47 59.63 56.67 57.61

170 109 30 309

55.02 35.28 9.71 100.00

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Table 2 Descriptive statistics for all sample firms Variable

n

Mean

Standard deviation

Lower quartile

Median

Upper quartile

ALIGN ACSZLG ACINDLG FINEXPLG GOVEXPLG BDSZLG BDINDLG SIZE SALES LEV DTACC DTACC1 BIG4 OCFTALG1 INCCHG LOSS SHRDECR SHRINCR

309 188 188 187 184 198 198 309 309 309 309 309 309 309 309 309 309 309

0.42 3.70 0.91 1.00 3.16 10.48 0.68 21.45 13,966.09 0.19 − 0.03 − 0.02 0.95 0.08 0.63 0.37 0.04 0.12

0.49 1.13 0.18 0.96 1.96 4.26 0.20 2.47 28,394.48 0.17 0.15 0.15 0.21 0.14 0.48 0.48 0.19 0.33

0.00 3.00 0.83 0.00 2.00 7.00 0.55 19.77 383.92 0.04 −0.06 −0.06 1.00 0.04 0.00 0.00 0.00 0.00

0.00 3.00 1.00 1.00 2.93 9.00 0.67 21.87 3161.16 0.17 −0.02 −0.02 1.00 0.08 1.00 0.00 0.00 0.00

1.00 4.00 1.00 1.00 4.33 13.00 0.85 23.25 12,507.83 0.29 0.03 0.04 1.00 0.14 1.00 1.00 0.00 0.00

(Teoh, Welch & Wong,1998). We include the variable SHRINCR to control for large increases in outstanding shares that may create incentives to increase earnings. Additionally, because managers have incentives to

reduce earnings in response to share repurchases, we include the variable SHRDECR to control for large decreases in outstanding shares (Becker et al., 1998). We expect the coefficients on SHRINCR and SHRDECR to be positive and negative respectively. 6. Sample selection Initially, firms in the European Union (SEC Form 20-F filers) are identified using the Compact D/SEC 2004 editions. Compact D/SEC listed all firms on the US stock exchanges. We focus on EU companies listed on the US stock exchanges since we can access these companies' financial information through COMPUSTAT. The initial sample is from the 279 EU firms listed on the US stock exchanges covered by Compact D/SEC. Boards of directors and their audit committee data (structure and composition) are hand-collected from the SEC Form 20-F filings. Since many firms do not have the necessary information in their 20-F, the final sample consists of 309 European Union firm year observations from 2002 to 2004. Panel A of Table 1 reports audit committee alignment of sample firms across years. The percentage of firms with alignment has increased from 28.18% in 2002 to 47.37% in 2004. For the whole sample across the three years, 42.39% of sample firms experienced audit committee alignment. Panel B of Table 1 reports audit committee alignment of sample firms across stock exchanges. Firms listed on the NYSE, NASDAQ and other exchanges have similar percentage of

Table 3 Correlations for all sample firms Panel A: determinants of alignment Variable

n

ALIGN

ACSZLG

ACSZLG

188

1.00

ACINDLG

188

FINEXPLG

187

GOVEXPLG

184

BDSZLG

198

BDINDLG

198

SIZE

309

LEV

309

− 0.01 (0.90) − 0.08 (0.30) − 0.16 (0.03) 0.15 (0.05) − 0.07 (0.35) − 0.18 (0.01) 0.00 (0.97) 0.05 (0.41)

ACINDLG

FINEXPLG

GOVEXPLG

BDSZLG

BDINDLG

SIZE

−0.02 (0.76) 0.27 (0.00) −0.19 (0.01) 0.37 (0.00) 0.01 (0.84) 0.33 (0.00) 0.10 (0.16)

−0.02 (0.79) −0.10 (0.17) −0.23 (0.00) 0.41 (0.00) −0.12 (0.10) −0.11 (0.14)

0.07 (0.37) 0.17 (0.02) 0.02 (0.74) 0.20 (0.01) −0.06 (0.39)

−0.03 (0.67) 0.02 (0.80) 0.12 (0.10) −0.002 (0.98)

− 0.20 (0.00) 0.53 (0.00) 0.17 (0.01)

0.04 (0.62) 0.04 (0.58)

0.25 (0.00)

ALIGN

BIG4

SIZE

OCFTALG

INCCHG

LOSS

LEV

1.00 1.00 1.00 1.00 1.00 1.00 1.00

Panel B: impact of alignment Variable

n

DTACC

DTACC1

DTACC1

309

1.00

ALIGN

309

BIG4

309

SIZE

309

OCFTALG

309

INCCHG

309

LOSS

309

LEVF

309

SHRDECR

309

SHRINCR

309

0.97 (0.00) − 0.13 (0.02) 0.12 (0.03) 0.09 (0.12) − 0.36 (0.00) 0.14 (0.02) − 0.16 (0.00) 0.06 (0.32) 0.04 (0.48) − 0.11 (0.05)

−0.11 (0.06) 0.14 (0.01) 0.10 (0.07) −0.37 (0.00) 0.14 (0.01) −0.18 (0.00) 0.04 (0.48) 0.05 (0.41) −0.12 (0.04)

LEV

SHRDECR

1.00 0.03 (0.61) 0.00 (0.97) −0.01 (0.88) −0.00 (0.95) −0.01 (0.85) 0.05 (0.41) 0.01 (0.84) 0.12 (0.04)

1.00 0.01 (0.83) −0.16 (0.01) −0.07 (0.21) 0.04 (0.50) 0.11 (0.06) −0.04 (0.46) −0.01 (0.82)

1.00 0.44 (0.00) 0.13 (0.03) −0.38 (0.00) 0.25 (0.00) −0.03 (0.60) −0.18 (0.00)

1.00 0.14 (0.01) − 0.46 (0.00) − 0.06 (0.16) − 0.03 (0.57) − 0.19 (0.00)

1.00 −0.35 (0.00) 0.08 (0.32) −0.03 (0.57) −0.02 (0.76)

1.00 0.07 (0.23) −0.04 (0.49) 0.18 (0.00)

1.00 0.05 (0.34) 0.03 (0.65)

1.00 −0.07 (0.21)

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Table 4 Comparison for all sample firms with and without alignment Difference Variable

Without alignment n

With alignment

Mean

Median

n

Mean

Median

Mean

Median

(t-value)

[Z-score]

0.03 (0.13) 0.03 (1.05) 0.31 (2.22)⁎⁎ −0.57 (−1.98)⁎⁎ 0.57 (0.93) 0.07 (2.52)⁎⁎ 1661.49 (0.52) −0.02 (−0.83) 0.04 (2.16)⁎⁎ 0.03 (1.75)⁎ −0.01 (−0.52) 0.01 (0.15) 0.00 (0.06) 0.01 (0.18) −0.01 (−0.21) −0.08 (−1.99)⁎⁎

0.00 [0.81] 0.00 [−0.72] 0.00 [−2.53]⁎⁎⁎ −0.62 [2.03]⁎⁎ 1.00 [−1.17] 0.13 [−2.73]⁎⁎⁎ −482.13 [0.16] −0.04 [1.25] 0.02 [−2.75]⁎⁎⁎ 0.02 [−1.90]⁎ 0.00 [0.52] 0.00 [−0.57] 0.00 [−0.06] 0.00 [−0.18] 0.00 [0.21] 0.00 [2.06]⁎⁎

ACSZLG

94

3.72

3

94

3.69

3.00

ACINDLG

94

0.92

1.00

94

0.89

1.00

FINEXPLG

94

1.16

1.00

93

0.85

1.00

GOVEXPLG

92

2.88

2.67

92

3.45

3.29

BDSZLG

99

10.77

10

99

10.20

9.00

BDINDLG

99

0.72

0.72

99

0.65

0.60

SIZE

178

14,670.47

3034.76

131

13,008.98

3516.89

LEV

178

0.18

0.15

131

0.20

0.19

DTACC

178

−0.01

− 0.01

131

−0.05

−0.03

DTACC1

178

−0.01

− 0.01

131

−0.04

−0.03

BIG4

178

0.95

1.00

131

0.96

1.00

OCFTALG

178

0.08

0.09

131

0.07

0.08

INCCHG

178

0.63

1.00

131

0.63

1.00

LOSS

178

0.38

0.00

131

0.37

0.00

SHRDECR

178

0.03

0.00

131

0.04

0.00

SHRINCR

178

0.09

0.00

131

0.17

0.00

⁎, ⁎⁎, ⁎⁎⁎ significant at the 0.10, 0.05, and 0.01 levels respectively, two-tailed test.

alignment. The percentage of firms with alignment ranges from 40.37% for NASDAQ firms to 43.53% for NYSE firms. 7. Data analysis 7.1. Univariate tests Table 2 shows the descriptive statistics for all sample firms. Because not every firm is providing audit committee and board of director information in their 20-F, the number of observations for audit committee and board related variables range from 184 for audit committee governance experience variable (GOVEXPLG) to 198 for board independence level variable (BDINDLG). The average audit committee size (ACSZLG) is 3.70 and the median is 3 members. The average audit committee exhibits high independence level (ACINGLG) at 91%. On average, there is one financial expert (FINEXPLG) sitting on the audit committee. In total, members of the audit committee sit on 11 other boards (GOVEXPLG). The average board size (BDSZLG) is around 10 members and the percentage of independent board members (BDINDLG) is 68%. The median sales (SALES) are 3161.16 million, indicating that the median EU firm listing on the US stock exchanges is quite large. The inter-quartile range from 383.92 million to 12,507.83 million shows that there is a large variation of firm size. The average ratio of long-term debt to total assets (LEV) is 0.19. The median of discretionary accruals (DTACC) and performance-adjusted discretionary accruals (DTACC1) are both −0.02.10 About 95% of sample 10 Dechow, Sloan and Sweeney (1995) document that estimated discretionary accruals are negatively biased for firms with low earnings and positively biased for firms with high earnings. Following Cohen, Dey and Lys (2005), we include a measure of current operating performance, current cash flows from operations excluding extraordinary items, to attenuate this bias. The estimation procedure is very similar to the calculation of discretionary accruals except that operating cash flow deflated by lagged asset is added to both the estimation equation and the calculation equation.

firms use Big 4 as their auditor. The average ratio of operating cash flow to beginning total assets (OCFTALG1) is 0.08. About 63% of sample firms report income increase (INCCHG) and 37% report loss (LOSS). About 4% of sample firms report a decrease in outstanding shares (SHRDECR) while 12% of sample firms report an increase in outstanding shares (SHRINCR). Panel A of Table 3 shows the correlation of variables for the determinants of alignment. Audit committee financial expertise is significantly negatively related to alignment, which means that firms already having a financial expert on their audit committee are less likely to engage in audit committee alignment. Audit committee governance experience is significantly positively related to alignment. Firms with more independent board are less likely to engage in audit committee alignment, probably due to these firms that already have higher audit committee independence level. This is confirmed by the positive correlation between board independence and audit committee independence. Among the independent variables, larger audit committees are more likely to have financial expert and have more governance experience. Larger boards and larger firms are more likely to have larger audit committees. More independent boards are more likely to have more independent audit committees. Panel B of Table 3 shows the correlation of variables for the impact of alignment. The two measures of discretionary accruals are highly correlated. Firms with audit committee alignment are less likely to engage in income-increasing earnings management. This shows that audit committee alignment not only satisfies regulatory requirement, but also reduces firms' earnings management behavior. Surprisingly, Big 4 is positively related to both types of discretionary accruals. This is probably due to the lack of variation for the Big 4 variable since more that 95% of our sample firms are audited by Big 4.

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Firms with good performance as evidenced by operating cash flow are less likely to engage in income-increasing earnings management. Firms that reported an increase in earnings are more likely to use discretionary accruals to reach this goal. Firms already incurring a loss are more likely to decrease earnings further, which is consistent with bath-taking behavior to save income for the future. Table 4 shows the mean and median comparison for all sample firms with and without audit committee alignment. The firms with audit committee alignment have lower prior level of financial expertise, which means that these firms are engaging in alignment to improve their financial expertise level. Contrary to our expectation, firms with audit committee alignment have a higher prior level of governance expertise. Fama (1980) and Fama and Jensen (1983) propose that directors make costly investments to develop reputations as effective monitors of corporate performance. So audit committee members sitting on more boards have incentives to engage in audit committee alignment to develop and maintain their reputation in the labor market. Audit committee members sitting on more boards of other firms are more likely to encourage an alignment to improve audit committees. Firms with audit committee alignment have lower prior board independence level. This suggests that less independent boards are more likely to have an alignment to improve audit committee. Firms with audit committee alignment report lower discretionary accruals and performance-adjusted discretionary accruals, which shows that audit committee alignment constrains earnings management. Firms with alignment are also more likely to issue shares, which shows that firms are more likely to improve their audit committee when they issue shares. 7.2. Multivariate test Table 5 shows the logistic regression results of the determinants of audit committee alignment. Lagged level of audit committee and board variables are used in Model 1. Our main analysis uses lagged

Table 5 Logistic regression results between dichotomous dependent variables alignment and independent variables (NEW) Model 1: ALIGNit = b0 + b1ACSZLGit − 1 + b2ACINDLGit − 1 + b3FINEXPLGit − 1 + b4GOVEXPLGit − 1 + b5BDSZLGit − 1 + b6BDINDLGit − 1 + b7SIZEit + b8LEVit + ɛit Model 2: ALIGNit = b0 + b1ACSZit + b2ACINDit + b3FINEXPit + b4GOVEXPit + b5BDSZit + b6BDINDit + b7SIZEit + b8LEVit + ɛit Variable

INTERCEPT ACSZLG ACINDLG FINEXPLG GOVEXPLG BDSZLG BDINDLG ACSZ ACIND FINEXP GOVEXP BDSZ BDIND SIZE LEV No. of observations Pseudo R2

Predicted sign

Model 1 Estimated coefficients

Wald chi-square

Estimated coefficients

Model 2 Wald chi-square

? − − − − − − − − − − − − ? ?

−0.47 0.18 0.01 −0.51 0.19 −0.08 −2.27

0.07 1.22 0.00 6.26⁎⁎⁎ 4.82 2.76⁎⁎ 6.29⁎⁎⁎

−0.81

0.35

−0.17 1.30 0.13 0.05 −0.07 −1.88 0.07 0.97

1.64⁎ 2.58 1.01 0.45 3.17⁎⁎ 7.62⁎⁎⁎ 1.23 1.80

0.10 −0.33 183

1.54 0.11 309

14.13%

6.19%

⁎, ⁎⁎, ⁎⁎⁎ significant at the 0.10, 0.05, and 0.01 levels respectively, on a one-tailed test for coefficients with sign prediction and a two-tailed test without sign predictions.

Table 6 Impact of the audit committee alignment on earnings management Model 3: DTACCit = b0 + b1ALIGNit + b2BIG4it + b3SIZEit + b4OCFTALGit + b5INCCHGit + b6LOSSit + b7LEVit + b8SHRDECRit + b9SHRINCRit + ɛit Variable

Predicted sign

Estimated coefficients

t-value

INTERCEPT ALIGN BIG4 SIZE OCFTALG INCCHG LOSS LEV SHRDECR SHRINCR Adjusted R2

? − − ? − + ? + − +

−0.20 −0.04 0.02 0.01 −0.66 0.03 −0.11 0.09 0.004 −0.06 31.95%

−2.39⁎⁎ −2.63⁎⁎⁎ 0.64 3.01⁎⁎⁎ −10.91⁎⁎⁎ 1.75⁎⁎ −5.74⁎⁎⁎ 1.95⁎⁎ 0.10 −2.54

⁎, ⁎⁎, ⁎⁎⁎ significant at the 0.10, 0.05, and 0.01 levels respectively, on a one-tailed test for coefficients with sign prediction and a two-tailed test without sign predictions. All t-statistics are based on the Newey and West (1987) standard errors corrected for serial correlation and heteroskedasticity.

variables in Model 1 to distinguish between whether a larger, more independent audit committee and boards as well as an audit committee with greater financial and governance expertise leads to audit committee alignment. The regression results in Model 1 indicate that firms with audit committees possessing greater financial expertise, with larger boards and more independent boards are less likely to engage in audit committee alignment. It is probably that firms associated with larger and more independent boards and audit committees possessing greater financial expertise already have a good audit committee, thus reducing the need to go through alignment to improve the audit committee. Surprisingly, we find that firms with audit committees possessing greater governance expertise are more likely to engage in alignment. This is consistent with Fama (1980) and Fama and Jensen (1983) that directors have incentives to make costly investments such as audit committee alignment to develop their reputation in the labor market. As a sensitivity check, we re-estimate Model 1 using contemporaneous measures of audit committee and board variables. The regression shows that firms with larger and more independent boards are less likely to have audit committee alignment, which is consistent with the results using lagged board variables. Audit committees with higher independence level are more likely to have audit committee alignment. Given the endogeneity concern associated with using contemporaneous measures of audit committee and board variables, we put more focus on the results using lagged measures of audit committee and board variables. Table 6 shows the regression investigating the impact of audit committee alignment on earnings management. All t-statistics in Table 6 are based on the Newey and West (1987) standard errors corrected for serial correlation and heteroskedasticity. Both discretionary accruals and performance-adjusted discretionary accruals give similar results. The regression results show that audit committee alignment is associated with less incomeincreasing earnings management. Some control variables are also significant. Larger firms are more likely to engage in earnings management. Firms with strong operating cash flows are less likely to engage in earnings management since these firms already have very good performances. Firms which report an increase in income are more likely to use discretionary accruals to reach the goal. Firms which incur losses are more likely to push income down further through accruals, which is consistent with bath-taking behavior. It seems that these firms are saving income so that they can report better income number in later periods. There is also

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evidence showing that firms with higher leverage engage in more earnings management, probably to satisfy the debt covenant requirements. 8. Conclusions We investigate audit committee alignment for EU firms listed on the US stock exchanges. This study is prompted by the EU 8th Directive on Company Law. This EU 8th Directive requires all EU public companies to have audit committee. Results of a logistic regression analysis suggest that firms with audit committees possessing greater financial expertise, with larger boards and more independent boards are less likely to engage in audit committee alignment while firms with audit committees possessing greater governance expertise are more likely to engage in alignment. In addition, we find that firms associated with audit committee alignment engage in less earnings management. We contribute in the following areas to the literature: (1) we document that the audit committee alignment decision is related to a firm's current board and audit committee characteristics. A firm already having a good audit committee is less likely to engage in audit committee alignment since alignment is a costly process; (2) we document that audit committee alignment is related to less earnings management. This shows that audit committee becomes more effective monitors after alignment; (3) we provide initial evidence on the impact of the EU 8th Directive on audit committees.

269

conflicts of interest for auditors and to enhance the EU's protection against Enron-type scandals” (Commission of the European Communities, 2004). The Commission also asserted that the International Standards on Auditing (International Auditing and Assurance Board) will be required for all EU statutory audits from 2005 as well as the creation of an Audit Regulatory Committee and a renamed Audit Advisory Committee. Finally, the main driver for the EU 8th Directive is the establishment of a single European capital market with 7000 listed companies, including the improvement and harmonization of approximately two million statutory audits conducted annually in the EU. In sum, a major collateral objective is to establish an equivalent legal and regulatory system developed by the US Public Company Accounting Oversight Board. In May 2006, the European Parliament and the Council of the European Union reaffirmed its aforementioned position on audit committees and issued the following final rules contained in Article 41: under Directive 2006/43/EC (OJL/57/103)12:

The Eighth Council Directive 84/253/EEC of April 10, 1984 on the approval of persons responsible for carrying out the statutory audits of accounting documents deals primarily with the approval of statutory auditors in Member States. Although the Directive contains some requirements on registration and professional integrity, it does not include requirements on how a statutory audit should be conducted and the degree of public oversight or external quality assurance which is needed to ensure a high audit quality.11 The need for the intervention by the EU is driven by the recent scandals, such as Parmalat, Ahold and others which confirm the urgency and need for the initiatives on statutory audits. For example, the new directive requires an independent audit committee for all public-interest entities and deals with the approval of auditors, clarifying these duties of statutory audits, their independence and ethics, a requirement for external quality assurance, ensuring robust public oversight over the audit profession, and improving cooperation between competent authorities in the EU. The objectives are “to ensure that investors and other interested parties can rely on the accuracy of the audited accounts, to prevent

1. Each public-interest entity shall have an audit committee. The Member State shall determine whether audit committees are to be composed of non-executive members of the administrative body and/or members of the supervisory body of the audited entity and/or members appointed by the general meeting of shareholders of the audited entity. At least one member of the audit committee shall be independent and shall have competence in accounting and/or auditing. In public-interest entities Member States may permit the functions assigned to the audit committee to be performed by the administrative or supervisory body as a whole, provided at least that when the chairman of such a body is an executive member, he or she is not the chairman of the audit committee. 2. Without prejudice to the responsibility of the members of the administrative, management or supervisory bodies, or of other members who are appointed by the general meeting of shareholders of the audited entity, the audit committee shall, inter alia: (a) monitor the financial reporting process; (b) monitor the effectiveness of the company's internal control, internal audit where applicable, and risk management systems; (c) monitor the statutory audit of the annual and consolidated accounts; (d) review and monitor the independence of the statutory auditor or audit firm, and in particular the provision of additional services to the audited entity. 3. In a public-interest entity, the proposal of the administrative or supervisory body for the appointment of a statutory auditor or audit firm shall be based on a recommendation made by the audit committee. 4. The statutory auditor or audit firm shall report to the audit committee on key matters arising from the statutory audit, and in particular on material weaknesses in internal control in relation to the financial reporting process. 5. Member States may allow or decide that provisions laid down in paragraphs 1 to 4 shall not apply to any public-interest entity that has a body performing equivalent functions to an audit committee, established and functioning according to provisions in place in the Member State in which the entity to be audited is registered. In such a case the entity shall disclose which body carries out these functions and how it is composed.

11 See Proposal for a Directive of the European Parliament and of the Council on Statutory Audit of Annual Accounts and Consolidated Accounts and amending Council Directives 78/660/EEC and 83/349/EEC, March 16, 1984, see Office Journal L 126, December 5, 1984.

12 Directive 2006/43/EC of the European Parliament and of the Council on Statutory Audits of Annual Accounts and Consolidated Accounts, amending Council Directives 78/660/EEC and 83/349/EEC and repealing Council Directive 84/253/EEC. Official Journal of the European Union, May 17, 2006.

Acknowledgements We thank Charles Cullinan, conference participants at the 2006 American Accounting Association Annual Meeting and the 2006 American Accounting Association Northeast Regional Meeting for their helpful comments. Appendix A Appendix A.1. Part A: institutional background

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Appendix A.2. Part B: comparison between the EU 8th Directive and Sarbanes–Oxley Act 2002 Subject matter

EU 8th Directive

Sarbanes–Oxley Act

Registration of audit firm

Mandates registration of statutory auditor and audit firms in any Member State

Auditor independence

Provider for possible total prohibition of the auditor to offer non-audit services to his audit client

Public Company Accounting Oversight Board requires annual State registration; audit firms with less than 100 public companies must file every three years PCAOB establishes independence of audit firms and prohibits certain non-audit services and requires preapproval from the audit committee for other non-audit

Requires statutory auditors and audit firms to be subject to robust professional ethics Auditing standards All statutory audits should be carried out in accordance with International Standards on Auditing (IAASB) Auditor rotation Requires audit partner rotation at five years⁎ Audit firm rotation Requires rotation at seven years⁎ Group auditor Group auditor bears full responsibility for the audit report in responsibility relation with the consolidated accounts, including the review performed by another audit firm which audits part of the group Quality assurance All statutory auditors and audit firms to be subject to a system of quality assurance Investigations and Member States shall implement effective system of sanctions investigations and sanctions which may be civil, administrative or criminal against audit firms, including public disclosure Public oversight over the audit profession Provides a minimum requirement for an adequate public oversight at Member State level, including a majority of nonpractitioners to oversee the audit profession Appointment and dismissal Requires that the statutory auditor or audit firm is independent from those who prepare financial statements for the audited entity. Reasons for dismissal and registration shall be disclosed to the responsible oversight authorities Independent audit committees Audit committees must Requires an independent audit committee of all public-interest disclose whether or not, and if not the committee has at entities, including at least one financial expert least one member who is a financial expert Professional ethics

Internal controls

Audit regulatory committee Audit advisory committee

Requires the statutory auditor or audit firm report on internal controls

Composed of representatives of Member States and of the profession

Requires audit partner rotation at five years No requirement for audit firm rotation at seven years No requirement for group auditor responsibility

PCAOB establishes quality control standards of audit firms PCAOB is empowered to do investigation and sanctions

PCAOB oversees the audits of public companies

The independent audit committee is responsible for the appointment, compensation, and dismissal of the registered public accounting firm. Requires an independent audit committee of each issuer, including complaints from whistleblowers Audit committees must disclose whether or not, and if not the committee has at least one member who is a financial expert Requires management to assess and report on internal controls and the audit firm attest to and report on the assessment made by management PCAOB Not applicable

⁎The final rules contained in Article 42, Independence, require audit partner rotation within a maximum period of seven years. Moreover, the requirement of audit firm rotation at seven years was not adopted by the Commission of the European Communities of the European Parliament and of the Council, see Official Journal L 157/104, May 17, 2006.

Appendix A.3. Part C: the present and future global presence of audit committees

EU 25 Member States⁎

Countries with audit committees

Austria Belgium Cyprus Czech Republic Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Latvia Lithuania Luxembourg Malta The Netherlands Poland Portugal Slovakia Slovenia Spain Sweden United Kingdom

Australia Canada France Hong Kong India Malaysia The Netherlands New Zealand Saudi Arabia Singapore South Africa Thailand United Kingdom United States

⁎Article 39 of the EU 8th Directive on Company Law mandates audit committees.

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