The association between corporate governance and earnings quality: Further evidence using the GOV-Score

Advances in Accounting, incorporating Advances in International Accounting 24 (2008) 191–201

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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

The association between corporate governance and earnings quality: Further evidence using the GOV-Score Wei Jiang a,1, Picheng Lee b,⁎, Asokan Anandarajan c,2 a b c

California State University, Fullerton, 800 N State College Boulevard, Fullerton, CA 92834-6848, United States Pace University, 1 Pace Plaza, New York, NY 10038, United States New Jersey Institute of Technology, School of Management, 300 CAB, University Heights, Newark, NJ 07102-1982, United States

a r t i c l e

i n f o

Keywords: Corporate governance Earnings management Discretionary accruals Sarbanes Oxley Act

a b s t r a c t This paper reexamines the relation between corporate governance and quality of earnings using a summary governance measure. Prior research has used many surrogates for corporate governance including size and composition of board of directors, existence and composition of audit committee, and extent of institutional ownership. However, the criticism of the extant research has been that corporate governance comprises many facets and is not uni-dimensional. In this study we fill this void by using the Gov-Score developed by Brown and Caylor [Brown, D., and Caylor, M.L., (2006). Corporate governance and firm valuation. Journal of Accounting and Public Policy 25, 409–434.] to measure corporate governance. In the post-Sarbanes–Oxley period, we find evidence of a significant inverse relationship, namely higher levels of corporate governance are associated with lower absolute discretionary accruals and higher quality of earnings. Furthermore, our results suggest that only firms in the highest category of corporate governance experience significantly improved quality of earnings. Finally, as a test of robustness, we document that corporate governance is negatively associated with small earnings surprises. This implies that firms with weak corporate governance are more likely to manage earnings in order to meet or beat analyst forecasts. © 2008 Elsevier Ltd. All rights reserved.

1. Introduction Corporate governance is defined by the Public Oversight Board as “those oversight activities undertaken by the board of directors and audit committees to ensure the integrity of the financial reporting process” (POB 1993). One of the most important functions of corporate governance is to ensure the quality of the financial reporting process. The issue of corporate governance has become more important due to the highly publicized financial reporting frauds at Enron, Worldcom, Adelphia and Parmalat, in particular, and a very high level of earnings restatements (Core, Holthausen, & Larcker, 1999; Loomis, 1999; Palmrose & Scholz 2004). Academic research has found an association between poor corporate governance and greater earnings management, implying lower quality. Prior studies have also found an association between poor corporate governance and weaker financial controls and higher levels of financial statement fraud (Beasley, 1996; DeChow, Sloan, & Sweeney, 1995; Klein, 2002). Overall, empirical research has documented a direct link between governance mechanisms and the reliability of financial reporting. ⁎ Corresponding author. Tel.: +1 212 618 6424. E-mail addresses: [email protected] (W. Jiang), [email protected] (P. Lee), [email protected] (A. Anandarajan). 1 Tel.: +1 714 278 2225. 2 Tel.: +1 973 596 8568. 0882-6110/$ – see front matter © 2008 Elsevier Ltd. All rights reserved. doi:10.1016/j.adiac.2008.08.011

This study provides further insight into the relation between corporate governance to earnings quality using a broad measure of governance based on the work of Brown and Caylor (2006). They developed a corporate governance score (referred to as Gov-Score) to examine whether firms with weaker corporate governance performed more poorly than firms with stronger corporate governance. The GovScore is a composite index consisting of 51 internal and external characteristics that are individual measures of governance. Using the Gov-Score, they found that better-governed firms are relatively more profitable, more valuable, and pay out more cash to their shareholders. The use of Gov-Score as a governance measure complements prior studies that used different individual surrogates to measure corporate governance. Larcker and Richardson (2004) contend that each surrogate by itself has limited ability to measure the entire construct of corporate governance. They note that there are many potential monitoring mechanisms designed to mitigate the inherent agency problems in a publicly traded firm. Examining one factor (example, auditor) in isolation of alternate governance mechanisms provides an incomplete analysis of the determinants of earnings quality. Bhagat and Jefferris (2002) also made similar comments. As an alternative approach to the individual constructs designed to measure specific dimensions of the governance structure, the Gov-Score allows us to examine the aggregate impact of the various governance mechanisms as a whole. We extend Brown and Caylor's (2006) study by applying their GovScore in the context of the quality of earnings. Our sample consists of

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4311 firm-years from the 2002–2004 post-Sarbanes–Oxley era, a period in which corporate governance practices were subject to increased scrutiny from investors, regulators and the media. We perform two sets of analyses. First, we regress our proxy of earnings quality (as measured by the absolute value of discretionary accruals) on the raw Gov-Score. Second, to measure the incremental impact of different levels of corporate governance, we partition our sample into three categories of Gov-Scores and then regress our proxy for earnings quality on these partitioning indicator variables. Overall, we find an inverse association between corporate governance and discretionary accruals in our sample period. In particular, higher corporate governance appears to be associated with significantly lower discretionary accruals. This finding is consistent with prior research using individual measures of corporate governance. We also find that lower earnings quality (higher absolute discretionary accruals) is associated with shorter auditor–client tenure, smaller firms, higher expectations of growth, lower operating cash flows and higher litigation risk, leverage, greater operating volatility, and a higher incidence of being audited by a Big4 firm. Our results are robust to alternative measures of earnings quality. More importantly, when we partition firms into strong, medium and weak corporate governance groups, we find evidence that firms with strong corporate governance show considerably greater reduction in the absolute discretionary accruals as compared to other firms with medium or weak governance. This suggests that, although earnings quality tends to improve as firms move up the scale of corporate governance, only firms with truly strong corporate governance regimes experience significant improvements in the quality of earnings. Finally, as a test of robustness, we document that corporate governance is negatively associated with small earnings surprises. This implies that firms with weak corporate governance are more likely to manage earnings in order to meet or beat analyst forecasts. The remainder of the paper is organized as follows. Section 2 reviews related research. Section 3 develops the hypothesis and describes the research design. Section 5 presents the empirical results. Section 6 summarizes and concludes. 2. Prior research and hypothesis development We dichotomize the research pertinent to our study into two broad categories. The first category discusses the findings of studies that examine the association between earnings management and corporate governance. There have been many surrogates used for corporate governance including age and tenure of the CEO, board size, characteristics of board of directors, existence and characteristics of audit committees and institutional ownership. This group of studies dates back three decades. The second category of studies considered here deals with earnings quality in the post-Sarbanes Oxley period. Unlike the first category, the published literature in this category is sparse because the topic is recent. 2.1. Earnings management and aspects of corporate governance The research is presented in chronological order. Initial research in this area, published twenty to thirty years ago, surrogated age and tenure of the CEO for corporate governance. These studies conclude that the older CEO or the longer his/her tenure, the better the performance of the firm (Alderfer, 1986; Bacon & Brown 1973). Some of the early research surrogated institutional ownership for corporate governance. The researchers find evidence that when large institutions are the primary stockholders, managers' behavior with respect to managing earnings is constrained. The theory is that large institutions closely monitor the organizations in which they invest thus acting as a disincentive for managers to act opportunistically or in a self-serving way (Del Guercio & Hawkins, 1999; Hartzell & Starks, 2003; McConnell & Servaes, 1990; Nesbitt, 1994; Smith, 1996). The

overall conclusion is that institutional ownership is associated with lower discretionary accruals. Researchers also surrogated board size for corporate governance. They conclude that the size of the firm's board is positively related to earnings management. The smaller the board size, the lower the discretionary accrual and possibility of earnings management (Del Guercio & Hawkins, 1999 among others). Researchers also focused on board of director characteristics as a surrogate for corporate governance. These studies conclude that higher proportion of outside directors on the board of directors is associated with improved operating performance (Byrd & Hickman, 1992; Subrahmanyan, Rangan, & Rosenstein, 1997). Beasley (1996) specifically examine the relationship between board of directors and the likelihood of financial statement fraud. He finds that boards of no fraud firms are more likely to have a greater proportion of outside (non-employee) directors than fraud firms. Subsequently, researchers surrogated the presence and characteristics of audit committees for corporate governance. McMullen (1996) examines the association between the presence of an audit committee and various indicators of possible lapses in the financial reporting process. She finds that the existence of an audit committee is associated with the correction of quarterly earnings. Wild (1996) investigates the association of formation of an audit committee and quality of earnings. He finds that stock price increase is significantly greater in the presence of audit committees (relative to absence of audit committees). Klein (2002) examines the link between the independence of the board/audit committee and the magnitude of abnormal accruals. She finds that firms with a majority of independent board/audit committee members had a lower level of discretionary accruals. Klein's study demonstrates the importance of examining the quality of earnings and not just the incidence of earnings overstatement fraud. While the above research surrogated various factors for corporate governance to examine the impact of the corporate governance surrogates on firm performance and earnings quality, other research sought to examine if the level of corporate governance was linked to enforcement actions by the SEC. Dechow, Sloan, and Sweeney (1996), for example, find that firms subject to enforcement actions have weaker corporate governance structures, which provides incentives greater earnings management. To date the literature has focused on identifying an association between separate corporate governance factors and financial reporting quality. 2.2. Earnings quality literature using governance indices Bowen, Rajgopal, and Venkatachalam (2008) note that there are two theories with regard to manager behavior. The Efficient Contracting Theory asserts that managers in general, exercise accounting discretion in an efficient manner. In the long run, due to efficient managers, shareholder value is maximized (Christie & Zimmerman 1994). In contrast, the Opportunist Theory assumes that managers act with a short-term self-interest motive and use loopholes, for example, poor corporate governance structures, to manage earnings for short-term benefit (Frankel, Johnson, & Nelson, 2002; Klein, 2002). In this background, Bowen et al. sought to obtain a greater understanding of manager behavior. Their findings appear to indicate that, in accordance with Opportunistic theory, managers manipulate earnings and act in their own self-interest in the short-term. They then examined the association between accounting discretion and subsequent firm performance and noted a positive association. They conclude that, overall, the association between poor corporate governance and accounting discretion (i.e., the Opportunistic theory) can be discounted because subsequent firm performance is positive. One of the limitations of the Bowen et al. paper is that they used the Gomper's index (Gompers, Ishii, & Metrick, 2003) to measure corporate governance. Their results are contingent on the Gomper's index measuring all aspects related to corporate governance. However, the Gomper's index has been criticized as perhaps not being

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sufficiently broad in scope. Hence, a problem with using the Gomper's index is that it omits variables that could potentially measure other relevant aspects of corporate governance (Bebchuk, Cohen, & Ferrel, 2005). The Gov-Score developed by Brown and Caylor used in our study spans 51 aspects of corporate governance (as opposed to 24 in the Gomper's index) covering eight categories. Bebchuk et al. note that, relative to the Gomper's index, the Gov-Score is much broader in scope with respect to governance factors and covers more firms, is more dynamic and is more reflective of changes in the corporate governance environment. Our study focuses on the first stage examined in Bowen et al.'s paper, i.e., the negative association between corporate governance and accounting discretion. The main thrust of our paper is to evaluate the usefulness of the Gov-Score in explaining the level of accounting discretion. Our research adds to the Bowen et al. study in that they used the Gomper's index and didn't find any significant relation between the Gomper's index and absolute accruals3. Our paper finds a significant relationship between Gov-Score and accounting discretion (as measured by the level of absolute accruals based on improved discretionary accrual models and small earnings surprises). In another related study, Larcker, Richardson, and Tuna (2007) use a sample of over two thousand firms and, using principal components analysis, derive 14 structural measures of corporate governance including, but not limited to, board characteristics, stock ownership, institutional ownership, activist ownership, existence of debt holders, mix of executive compensation and anti-takeover variables. They examine the association of these 14 constructs with measures related to operating performance including abnormal accruals. They find that these indices have a mixed association with abnormal accruals. Our study adds to the Larcker et al. study in that we use a Gov-core that is one composite measure of corporate governance rather than 14 separate governance constructs. The result with respect to the association of the 14 corporate governance measures and abnormal accruals were inconclusive in the Larcker study. Our results with respect to the Gov-Score and discretionary accruals are significant and conclusive. In our study, using the single Gov-Score index we find a significant inverse relationship, namely, that higher levels of corporate governance are associated with lower absolute discretionary accruals. Our research represents the first attempt to use the Gov-Score to examine the association between earnings management and a composite measure of corporate governance. Our results are more significant than those reported in Larcker (using the principal component approach) and Bowen et al. (using the Gomper's index). 3. Hypothesis development and model specification The Gov-Score is a broad measure of corporate governance comprising both external and internal governance mechanisms. It comprises 51 factors that span eight categories; audit, board of directors, charter/by laws, director education, executive and director compensation, ownership, progressive practices and state of incorporation. These will be discussed individually. Audit comprises measures such as: • Does the audit committee consist solely of independent outside directors? • Were auditors ratified at the most recent annual general meeting? • Are consulting fees paid to auditors less than audit fees? • Does company have a formal policy on auditor rotation?

3 Their discretionary accrual measure is based on the modified Jones model. We use an alternative measure that corrects for potential misclassification and have been proven to have more explanatory power.

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Board of directors comprise measures including, among others: • • • • •

Size of board Is the CEO and chairman the same or are duties separated? Is shareholder approval required to change board size? Is board controlled by more than 50% outside directors? Is the compensation committee comprised solely of independent outside directors? Charter/by laws comprises measures, including among others:

• Is a simple or supermajority vote required to approve a merger? • Are shareholders allowed to call special meetings? • Can board amend bylaws without shareholder approval? Director education: • Has at least one member of the board participated in an ISS accredited director education program? Executive and director compensation, including among others: • Were stock incentive plans adopted with shareholder approval? • Is option repricing prohibited? • Do directors receive all or a portion of their compensation in stock? Ownership, including among others: • Do directors with more than one year of service own stock? • Are executives/directors subject to stock ownership guidelines? • Extent of officers' and directors' ownership of stock (over 30%)? Progressive practices, including among others: • • • •

Does mandatory retirement age for directors exist? Is performance on board reviewed regularly? Is a board-approved CEO succession in place? Do director term limits exist? State of incorporation

• Is company incorporated in a state without any anti-takeover provisions? Each of 51 factors is coded 1 if the firm's governance is considered to be minimally acceptable or 0 otherwise. Gov-Score is computed as the sum of the firm's binary variables. Thus, higher values indicate stronger corporate governance. We chose Gov-Score over alternative measures of governance such as G-index (Gompers et al., 2003) or entrenchment index (Bebchuk et al., 2005) because Gov-Score is broader in scope with respect to measuring governance, covers more firms, is more dynamic, and is more reflective of recent changes in the corporate governance environment. Based on the extant literature, we propose the following hypothesis regarding the relation between corporate governance and earnings quality. Hypothesis. Higher level of corporate governance is associated with lower absolute discretionary accruals (higher earnings quality). We estimate OLS regression models and perform two sets of analyses to test our hypothesis. The first set of analyses is based on the raw Gov-Score constructed by Brown and Caylor (2006). Specifically, we estimate the following model with the measure of discretionary accruals (proxy for earnings equality) specified as a linear function of Gov-Score and control variables. Model 1. PMDACC = β0 + β1 GOVSCORE +∑ βj (Control Variablesj) + ε j Where j = 2, 3,…,12. PMDACC denotes the absolute value of the discretionary accrual measure, and GOVSCORE denotes the raw GovScore. The control variables are as defined in Table 1. Model 1 allows us to test whether the magnitude of discretionary accruals monotonically decreases in the level of corporate governance. We expect β1 to be negative.

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Table 1 Variable definitions Variables

Definition

The absolute value of the performance matched discretionary accrual measure GOVSCORE Corporate Governance Score computed based on Brown and Caylor (2006) FEERATIO Non-audit fee divided by total fee NAS 1 if the dollar amount of non-audit fees is grater than the 75th percentile value of sample firms and if the ratio of non-audit fees to total fees is greater than the sample median, 0 otherwise TENURE 1 if the auditor has audited the firm's financial statements for at least 3 years, 0 otherwise L1TA Last year's total accrual accruals computed as net income before extraordinary items LNMV The natural log of MVE, defined as the firm's price per share at fiscal yearend (Compustat data item #199) multiplied by the number of shares outstanding (Compustat data item #25) MB The firm's market-to-book ratio at its fiscal-year-end, defined as its MVE divided by stockholders' equity of common shareholders (annual Compustat data item #60) CFO Cash flow from operations (Compustat data item #308) scaled by beginning of year total assets (Compustat data item #6) LITIGATION 1 if the firm operates in a high litigation industry and 0 otherwise (high litigation industries are industries with SIC codes of 2833–2836, 3570– 3577, 3600–3674, 5200–5961, and 7370–7374 LEVERAGE A firm's total assets less its book value (Compustat data item #60) divided by its total assets STDCFO The standard deviation of annual operating cash flows computed over the three year window BIG4 1 if the auditor is a Big4 firm and 0 otherwise IND Industry dummies YEAR Year dummies

both β1 and β2 are negative, with β1 being more negative in magnitude. In addition, the difference between β1 and β2 is predicted to be statistically significant.

PMDACC

We also perform a second set of analyses in which we partition our sample using indicator variables. We do this for two reasons. First, Bebchuk et al. (2005) notes that using the raw score measures imposes a linearity constraint on the ordinal measures. This constraint may or may not be appropriate4. Second, this partitioning approach allows us to quantify the incremental effect of the Gov-Score on the absolute value of discretionary accrual. More specifically, we split our sample into three levels of corporate governance. We define HG (strong corporate governance) to take on the value of 1 if Gov-Score ≥ 29, and 0 otherwise, while MG (medium corporate governance) takes on the value of 1 if 24 ≤ Gov-Score ≤ 28, and 0 otherwise. Our choices for interval width are designed to capture unambiguously the high, medium and low levels of the governance factor. Roughly 35% of the firms are classified as having strong corporate governance regimes, 34% as having weak corporate governance, and the remaining 31% firms make up the middle partition. Using the partitioning scheme, we estimate the following regression model: Model 2. PMDACC = β0 + β1 HG + β2 MG + ∑ βj(Control Variables) + ε j Where j = 3, 4…12. HG and MG represent the partitioning indicator variables defined above, and all other variables are as defined in Model 1. As specified, the model allows us to estimate the incremental effect of the level of corporate governance for the three categories of firms. Based on Model 2, firms characterized by strong corporate governance have significantly lower discretionary accruals relative to other categories of firms. More specifically, we predict that

4 The raw Gov-Score is an ordinal measure. Including the discrete version of this variable on the right-hand side of an equation would result in it being treated as a cardinal variable. Specifically, it would implicitly assume that the quantitative effect of going from, for example, a low score (LG) to a medium score (MG) is the same as the quantitative effect of going from a medium score (MG) to a high score (HG). There is no particular reason that this should be the case. In other words, using the raw score implicitly imposes a “linear” restriction on the relation between the level of accruals and the Gov-Score. By partitioning our sample using indicator variables, we relaxed this constraint, and let the data determine whether the effect of moving from LG to MG is the same as moving from MG to HG.

4. Sample selection and variable definitions 4.1. Sample selection We are limited by availability of information relating to our measure of corporate governance, the Gov-Score. We select 2002, 2003 and 2004 for our sample years. From the list of companies for which the Gov-Score data is available, we exclude financial institutions (SIC codes 6000 to 6099) because these companies may have different incentives for earnings management relative to the other firms in our sample. We also exclude firms where there is insufficient information to calculate the discretionary accruals measure. Finally, audit fees data are obtained from the Auditanalytics database. All other information is obtained from Compustat. The final sample size resulting from this procedure is 4,311 observations. We use the absolute value of discretionary accruals as the dependent variable of interest to surrogate for earnings quality. We next discuss the model used to compute discretionary accruals. 4.2. Discretionary accruals measure The most common metrics used to detect earnings management, as mentioned above, is the magnitude of discretionary accruals. In this study, we adopt the performance matched abnormal accrual measure (Kothari, Leone, & Wasley, 2005) as the proxy for earnings quality5. As a first step, we estimate the cross-sectional modified Jones (1991) model shown below: TAit =Ait−1 ¼ α 1 þ β1 ½ΔREVit =Ait−1 −ΔARit =Ait−1  þ β2 ½PPEit =Ait−1  þ eit ð1Þ where, TAit

Ait − 1 ΔREVit ΔARit PPEit εit

total accruals, calculated as firm i's income before extraordinary items and discontinued operations (Compustat data item #123), minus cash flows from continuing operations (Compustat data item 6), plus extraordinary items and discontinued operations (Compustat data item #124) in year t; total assets (Compustat data item #6) for firm i in year t − 1, change in net revenues (Compustat data item #12) for firm i from year t − 1 to t; change in accounts receivable (Compustat data item #2) for firm i from year t − 1 to t; gross property plant and equipment (Compustat data item #7) for firm i in year t; error term for firm i in year t.

We estimate the model for each two-digit SIC industry with at least ten firms. Firms with total accruals or any of the independent variables in the extreme 1% tails of their respective distributions are winsorized. This approach enables us to control for industry-wide changes (DeFond & Jiambalvo, 1994). The coefficient estimates from Eq. (1) are then used to estimate the firm-specific normal accruals for our sample firms. The abnormal accruals are estimated as the difference between the total accruals and the fitted normal accruals. To adjust for firm performance, we partition firms within each two-digit SIC code into deciles based on their prior year's ROA. The performance matched

5 We also examine the robustness of our results using a measure of discretionary accrual developed by Dechow et al. (2003). This alternative measure yields substantively similar results in all analyses.

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discretionary accrual is the absolute value6 of the difference between a sample firm's abnormal accruals estimated using Eq. (1) and the median abnormal accruals for each ROA portfolio. This portfolio approach controls for relative performance across random samples. Adjusting for performance is important because prior research documents that discretionary accrual estimates are correlated with firm performance (Kasznik, 1999; Kothari et al., 2005). We label this measure as Performance Matched discretionary accruals (PMDACC). 4.3. Control variables We include several control variables that the literature documents could potentially influence earnings management. 4.4. Non-audit fees to total fees (FEERATIO) Frankel et al. (2002) use ratio of non-audit fees to total fees as a measure of auditor independence. They find that the ratio of non-audit fees to total fees has a positive relationship with the absolute value of total accruals. The higher the non-audit fees (indicating lower independence) the higher the absolute discretionary accruals, indicating greater earnings management. However, interestingly, Larcker and Richardson (2004) find a negative association between the level of fees paid to auditors and discretionary accruals. Higher fees appear to be associated with a lower degree of earnings management. They conclude that auditor fees are constrained by reputational effects. Since an association between audit fees and discretionary accruals has been determined, we include level of audit fees as a control variable. We do not postulate a sign for the coefficient of this variable. 4.5. Non-audit fees as a proportion of total audit fees (NAS) This is another measure used in prior research (Francis & Ke, 2006). NAS is a dummy variable representing the extent of non-audit fees as a proportion of total fees. NAS is coded one if the dollar amount of nonaudit fees is greater than the 75th percentile value of sample firms and if the ratio of non-audit fees to total fees is greater than the sample median. The definition of NAS identifies observations with more extreme values of non-audit services by considering both the absolute magnitude of non-audit fees and relative magnitude of non-audit fees. We use NAS as an alternative measure of auditor independence. 4.6. Auditor tenure (TENURE) We include this as a control variable because the general theory is that longer audit tenure may result in lower earnings quality (Dunham, 2002). Myers, Myers, and Omer (2003), however, find that longer auditor tenure is associated with higher earnings quality (lower discretionary accruals). They postulate that, in the current environment, longer auditor tenure, on average, results in auditors having greater influence, and, hence, use this influence to place constraints on aggressive management decision making with respect to earnings management. While an association between auditor tenure and earnings quality has been found, there is debate about the direction of this association based on the finding of Myers et al. We include this as a control variable but make no predictions about the sign of the coefficient. 4.7. Size (LNMV) Watts and Zimmerman (1978) suggest that large firms face greater political costs relative to small firms since larger firms are more subject to scrutiny from financial analysts and investors due to their 6 We use the absolute value of discretionary accruals because it allows us to test for differences in the tendency to manage earnings, without having to identify the particular incentive, time period, or expected direction for the earnings management.

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larger market capitalization and, hence, greater influence on the stock market. If this is true, then larger companies would have a greater incentive to decrease earnings. However, Lobo and Zhou (2006) note that large firms may have more opportunities to overstate earnings because of the complexity of their operations and the difficulty for users to detect overstatement. Either way, size is a variable that could potentially bias the coefficients of the variables of interest in our study. Hence, we include a size variable to control for potential earnings overstatement, but, as in Lobo and Zhou we make no prediction on the sign of the coefficient.7 Firm size is measured as the natural log of market value of equity. 4.8. Market to book ratio (MB) Summers and Sweeney (1998) note that unethical managers may be induced to misstate financial statements when growth slows or reverses, in order to maintain the appearance of consistent growth. The market to book ratio represents market expectations of future profitability growth. Trying to meet such expectations could be a major motive for managers and discretionary accruals is a useful tool to attain that objective. Market to book ratio is defined as market value of equity divided by book value of equity. We expect a positive coefficient for this variable. 4.9. Cash flow from operating activities (CFO) Lobo and Zhou (2006) and Becker, DeFond, Jiambalvo, and Subramanyan (1998) note that firms with strong operating cash flow performance are less likely to employ income increasing discretionary accruals to boost earnings because they are performing well. Conversely, firms with poor operating cash flow are more likely to employ income increasing discretionary accruals to send a positive signal to investors. Similar to Lobo and Zhang and Becker et al., we include a variable to control for the effect of poor operating cash flow. We expect the coefficient to be negative. 4.10. Litigation risk (LITIGATION) Palmrose (1999) reports that firms with high litigation risk are more likely to be concerned about missing earnings benchmarks and, hence, may have an incentive to manage earnings to achieve forecasted earnings targets. In this instance, high litigation risk may be associated with lower earnings quality. Khurana, Raman, and Wang (2006), however, examine the relation between litigation risk and earnings quality for a sample of 34 countries and conclude that litigation can motivate companies to increase transparency in financial reporting. Since an association between litigation risk and earnings quality have been reported we include litigation risk as a control variable but make no predictions about the sign of the coefficient. 4.11. Financial leverage (LEVERAGE) Financial leverage may also be associated with discretionary accruals. DeFond and Jiambalvo (1994) presents evidence that managers of highly leveraged firms have incentives to make income increasing discretionary accruals to avoid debt covenant violation. However, according to DeAngelo, DeAngelo, and Skinner (1994), troubled companies have large negative accruals related to contractual renegotiations that provide incentives to reduce earnings. The presence of debt-holders also offers additional monitoring benefit via external capital providers who have the incentive and ability to monitor firm activity to protect invested principle (Larcker & Richardson, 2006). Becker et al. (1998) find that leverage is negatively 7 In the “additional analyses” section, we conduct sensitivity analysis to investigate whether size affects our results.

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Fig. 1. Histogram of Brown and Caylor (2006) Gov-Score for the 2002–2004 Period. The Brown and Caylor (2006) Gov-Score range from 13 to 43 for our sample of 4311 firms. Descriptive statistics for the Gov-Score are provided in Table 2.

associated with the absolute value of discretionary accruals. LEVERAGE is measured as the ratio of total liabilities to total assets and is included to control for the possible effects (positive or negative) of firm risk. We make no prediction on the sign of the coefficient. 4.12. Volatility of operating cash flows (STDCFO) Minton and Schrand (1999) find that firms with greater earnings volatility have higher costs of equity and debt capital. Hence, riskier firms might use more discretionary accruals to reduce the perception of risk (Warfield, Wild, & Wild,1995) or to smooth earnings and lower their cost of equity capital. Hrisbar and Nichols (2006) argue that volatility in accruals is inherently related to volatility in the firm's operation and provide evidence of a high correlation between absolute measures of discretionary accruals and volatility of cash flows. Following Minton and Schrand (1999), we proxy for risk with the standard deviation of annual operating cash flows computed over the three-year window prior to the window over which the discretionary accrual variable is calculated (STDCFO). We expect the coefficient to be positive. 4.13. Big4 auditors (BIG4) Prior research suggests that Big5 auditors are less likely to allow earnings management than non-Big5 auditors (e.g., Ashbaugh, LaFond, & Mayhew, 2003; Becker et al., 1998; DeFond & Jiambalvo, 1991; DeFond & Jiambalvo,1994; Francis, Maydew, & Sparks,1999; Frankel et al., 2002). Thus, our analysis includes a Big4 indicator variable (BIG4) that equals one if the sample firm is audited by a Big4 firm and zero otherwise. 4.14. Reversal of accruals (L1TA) We add the prior year's total accrual (L1TA) to the model to capture the reversal of accruals over time. 4.15. Industry and year dummies (IND and YEAR) We also include two-digit industry dummies (IND) and year dummies (YEAR) to control for fixed industry and time effects. The definitions of the variables are shown in Table 1. 5. Discussion of results

Note that the Gov-Scores for our sample range from 13 to 43, and the distribution of scores is slightly skewed to the right. Panel A of Table 2 presents descriptive statistics on the variables used in our analysis. The mean (median) Gov-Score for sample firms is 26.588 (26) with the inter-quartile difference ranging from 22 to 31. The mean and median for the performance-matched absolute discretionary accruals (PMDACC) are 5.47% and 3.42% of total assets, respectively. The mean (median) ratio of non-audit fees to total fees (FEERATIO) is 0.3354 (0.3112), as compared to 0.4960 (0.5190) reported by Ashbaugh et al. (2003) for year 2000. The significant drop in the fee ratio was expected since our sample is restricted to the post-SOX period in which accounting firms are banned from providing most consulting services to their audit clients. The statistics for other control variables are very similar to those reported by Frankel et al. (2002) and Ashbaugh et al., (2003) for the pre-SOX period. On average, the natural log of a firm's market value of equity (LNMV) is 6.4085, and the average firm trade at a little over three times the book value. The mean of financial leverage (LEV) is 50.51%, and 38% of the firms reside in industries are characterized by high litigation risk. The cash flows from operations (CFO) is 7.32% of the total assets for the average firm. Panel B of Table 2 shows the changes in the discretionary accrual measure and Gov-Score from 2002 to 2004. For our sample period, we had 1,259 observations in 2002, 1,406 observations in 2003, and 1,646 observations in 2004, respectively. The absolute value of discretionary accruals is on average lower in 2003 and 2004 relative to 2002, although the magnitude of decline is relatively small. With respect to the level of corporate governance, we note that the average Gov-Score improved from 2002 to 2003 (22.7 to 26.16) and further improved in 2004 (29.9). This indicates that SOX significantly influenced corporate governance as measured by the Gov-Score. Year 2002 is probably more appropriate to be considered as the transitional period because even though SOX was signed into law in July 2002, some provisions didn't immediately go into effect in fiscal year 2002, and most companies had not implemented in that reporting year, but rather in the following years8. As a result, the increase in Gov-Score from 2002 to 2003 mostly reflects the implementation of the mandated provisions of SOX. Interestingly, the Gov-Score continued to rise into 2004. The continued improvement was most likely brought about by the mandated provisions enacted by major U.S. stock exchanges, or it could stem from the fact that companies strengthened the corporate governance on a voluntary basis in the post-SOX period.

5.1. Descriptive statistics Fig. 1 graphically depicts the frequencies for the Brown and Caylor (2006) Gov-Scores for our sample of 4311 firm-years. It indicates that Gov-Score 22, 23, 24 and 25 register the highest levels of frequencies.

8 In addition, the cut-off date for the Gov-Score is February 1st each year. Therefore, the fiscal year 2002 Gov-Score was collected for firms as of 2/1/2003, which preceded the effective dates of the relevant provisions of the SOX. It is reasonable to assume that some companies adopted SOX provisions after February 1st, but these changes were not incorporated into the Gov-Score compiled for fiscal year 2002.

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Next, we break down our sample into quintiles and compute the mean of the PMDACC for each quintile. The results are shown in Panel C of Table 2. We note that the absolute discretionary accruals decline as we move from the quintile representing the lowest Gov-Score to the quintile representing the highest Gov-Score. A t-test was performed to examine whether significant differences existed between the values of the Gov-Score in the two extreme quartiles. The results show significant difference at the 1% level (significance levels are based on two-tailed pvalues). These results provide preliminary evidence that higher corporate governance scores are associated with lower absolute discretionary accruals implying higher earnings quality. 5.2. Regression results To confirm the evidence emerging from the univariate analysis, we conduct two sets of multivariate analyses to further investigate the relation between corporate governance and absolute discretionary accruals by controlling for a set of firm-specific variables that are expected to affect the earnings quality. Table 3 displays the result of our first regression model. First, our results indicate that fee ratio of non-audit fee as a proportion of total audit fees is not significant in our sample. The literature has provided conflicting evidence. Dee, Lulseged, and Nowlin (2006) find that higher proportions of non-audit fees are associated with higher income increasing accruals implying lower quality of earnings. However, they also find that this association is moderated by client firm size. In particular, for smaller clients, higher fees are associated with higher levels of income decreasing accruals. They imply that auditors Table 2 Descriptive statistics Panel A: Variables used in discretionary accruals analysis (n = 4311) PMDACC GOVSCORE FEERATIO NAS TENURE L1TA LNMV MB CFO LITIGATION LEVERAGE STDCFO BIG4

Mean

STD

1st quartile

Median

3rd quartile

0.0547 26.5880 0.3354 0.3519 0.8021 −0.0846 6.4085 2.9441 0.0719 0.3763 0.5136 0.1203 0.8867

0.0667 5.6133 0.2043 0.4776 0.3984 0.0972 1.9437 3.4151 0.1522 0.4845 0.2846 0.2142 0.317

0.0122 22 0.17281 0 1 −0.1172 5.123 1.3587 0.0316 0 0.3002 0.0346 1

0.0342 26 0.3112 0 1 −0.0682 6.4175 2.0924 0.0865 0 0.4948 0.0624 1

0.0735 31 0.4747 1 1 −0.0333 7.689 3.4234 0.1478 1 0.6762 0.1142 1

Panel B: The absolute discretionary accrual measure and corporate governance score by year 2002 PMDACCa GOVSCOREb N

2003

2004

Mean

Median

Mean

Median

Mean

Median

0.0569 22.7037 1259

0.0363 22

0.0547 26.1686 1406

0.033 25

0.0555 29.9174 1646

0.0337 30

Panel C. Quintile means of the discretionary accrual measure sorted in descending order of governance score Quintile

PMDACC

GOVSCORE

1 2 3 4 5 Quintile 1–5 Significance level

0.0685 0.0638 0.0584 0.0463 0.0415 0.027 0.008

19.4183 23.0236 25.9092 29.4273 34.8130

Note: All variables are defined in Table 1. Quintiles are presented in the descending order of GOV-SCORE. The mean of each variable is shown for each quintile. A t-test was performed to test whether a significant difference exists between the means of GOVSCORE in the two extreme quintiles (quintile 1 and 5).

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Table 3 The association between the discretionary accrual measure and corporate governance score Variable

Coeff. estimate

p-value

Coeff. estimate

p-value

Intercept GOVSCORE FEERATIO NAS TENURE L1TA LNMV MB CFO LITIGATION LEVERAGE STDCFO BIG4 Industry dummies Year dummies Adjusted R2 N

0.0634⁎⁎ − 0.0011⁎⁎⁎ 0.0092

0.0221 0.0001 0.1180

0.0689⁎⁎⁎ − 0.0011⁎⁎⁎

0.0098 0.0001

0.0046 − 0.0937⁎⁎⁎ − 0.0052⁎⁎⁎ 0.0014⁎⁎⁎ − 0.0725⁎⁎⁎ 0.0081⁎⁎ 0.0244⁎⁎⁎ 0.0416⁎⁎⁎ − 0.0214⁎⁎⁎ Yes Yes 0.2041 4311

0.1141 b.0001 b.0001 b.0001 b.0001 0.0492 0.0010 b.0001 0.0003

0.0030 0.0044 − 0.0937⁎⁎⁎ − 0.0053⁎⁎⁎ 0.0014⁎⁎⁎ − 0.0722⁎⁎⁎ 0.0081⁎⁎ 0.0238⁎⁎⁎ 0.0417⁎⁎⁎ − 0.0217⁎⁎⁎ Yes Yes 0.2082 4311

0.2557 0.1212 b.0001 b.0001 b.0001 b.0001 0.0364 0.0019 b.0001 0.0002

PMDACC ¼ β0 þ β 1 GOVSCORE þ β 2 NONAUDIT FEE MEASUREðFEERATIO or NASÞ þβ 3 TENURE þ β 4 L1TA þ β5 LNMV þ β6 MB þ β 7 CFO þ β 8 Litigation þβ 9 LEVERAGE þ β 10 STDCFO þ β 11 BIG4 þ ∑ βj INDj þ ∑ β k YEARk þ e j

k

⁎⁎⁎, ⁎⁎, ⁎ indicate significance level at ≤1%, 5%, 10% respectively. All continuous variables are winsorized at 1% and 99% to mitigate outliers. All variables are as defined in Table 1.

may be more conservative with smaller clients relative to larger clients. The results in our study may be confounded due to the range in size of the firms in our sample9. We also include another variable NAS to measure auditor independence (a dummy variable representing 1 if the dollar amount of non-audit fees is greater than the 75th percentile value of sample firms and if the ratio of non-audit fees to total fees is greater than the sample median; 0 otherwise). This definition results in 28% of firm-quarter observations being classified as high NAS observations. The results again are not significant. The insignificant results from this study add to a long list of prior literature that report mixed evidence on the relation between auditor independence and earnings quality. Romano's (2005) survey of 25 studies on the effect of non-auditing services on audit quality reports that 15 studies show no connection between the provision of non-audit services and audit quality; one finds no connection when the auditors are the big 5 accounting firms, three find non-audit services improve audit quality, and the leading survey of the remaining six is inconclusive with respect to subsequent testing of other relevant factors, a problem that may infect the other surveys finding that non-audit services affect quality. Our results suggest that, in the post-SOX period, the lack of association may stem from legislation that limits the types of non-auditing services that auditors can provide to their clients. With regard to the audit tenure, we find that the coefficient of the audit tenure variable is positive and significant at the 5% level. This implies that, when the auditor–client tenure is long (three years or more), absolute discretionary accruals are higher. This finding corroborates the results of Dunham (2002) that longer audit tenure leads to lower earnings quality, but is contradictory to the results of Myers et al. (2003) that longer auditor tenure, on average, results in auditors having greater influence, and, hence, use this influence to place constraints on aggressive management decision making with respect to earnings management. Our study indicates that longer audit tenure is associated with higher absolute discretionary accruals. This may be due to the counter argument that clients are more comfortable with long term auditors and may coerce them into accepting their accounting adjustments. The coefficient of the size variable as measured by the natural log of market value of equity (LNMV) is negative and significant at the 1%

9

In Section 5.4, we conduct sensitivity analysis to investigate the “size affect”.

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level, supporting Watts and Zimmerman's (1990) argument that large companies face greater political costs and are more subject to scrutiny from media and investors, and thus less likely to manage earnings. The positive and significant coefficient on the market to book ratio (MB) suggests firms use discretionary accruals to manipulate earnings to meet the market expectations of growth. The estimate for cash flow from operations (CFO) is negative, consistent with companies masking their poor performance by managing earnings using discretionary accruals. With respect to litigation risk (LITIGATION), the coefficient of the indicator variable is positive and significant at the 5% level, indicating that firms in high litigation industries have greater incentive to manage earnings to achieve forecasted earnings targets. The remaining control variables are all statistically significant in the predicted direction. Financial leverage (LEVERAGE) is positively related to PMDACC, consistent with managers of highly leveraged firms decreasing accruals related to contractual renegotiations (DeFond & Jiambalvo,1994). Greater volatility of operating cash flows (STDCFO) is also correlated with a greater likelihood of managing earnings. Absolute discretionary accruals are lower for clients audited by a Big4 firm, suggesting that Big 4 auditors are less likely to allow earnings management than non-Big 4 auditors. In the post-SOX period, larger auditors likely seek to protect their reputation by being more stringent with firms with respect to the use of discretionary accruals for earnings management. Finally, and most importantly, our results show that corporate governance is negatively associated with the absolute discretionary accrual measure (PMDACC). The association is significant at the 1% level even after controlling for a variety of firm-specific factors that have been shown to affect the quality of earnings in prior research10. Overall, these results indicate that lower levels of corporate governance (as measured by the Gov-Score) is associated with higher levels of absolute discretionary accruals and hence, lower quality of earnings. This finding is consistent with previous studies that adopted single measures of corporate governance such as auditor type, existence and composition of audit committees, and size of board of directors. Given that each surrogate by itself has limited ability to measure the construct of corporate governance, we believe that our composite score approach provides further and more convincing evidence on the combined effect of internal and external governance factors on the quality of earning. We next test whether firms in the category of strong corporate governance (HG) have significantly lower absolute discretionary accruals relative to other categories of firms by estimating Model 2. As noted earlier, Model 1 imposes a linearity constraint on the coefficient estimate, and we relax this constraint in Model 2. Panel A of Table 4 reports the results of our regression analyses of the partitioned corporate governance. With respect to the control variables, we observe results that are very similar to those obtained from Model 1. LNMV and BIG4 are negatively and significantly associated with PMDACC. MB, TENURE, LITIGATION, LEVERAGE and STDCFO are positively and significantly associated with PMDACC, while FEERATIO and NAS are insignificant. With respect to the indicator variables on corporate governance, the coefficients on HG and MG, as expected, carry negative signs and are monotonically decreasing in the strength of corporate governance, but only the coefficient on HG is significant at 1% level (p-value = 0.00). Note that the coefficient on HG is more negative in magnitude than that on MG. This suggests firms in the highest category of corporate governance experience significantly lower absolute discretionary accruals. To provide more evidence on the incremental reduction in the absolute value of discretionary accruals by the regression coefficients for the three categories of firms, we test for the significance of the difference between β1 and β2 (i.e. the average reduction in absolute discretionary accruals by 10 To address the outlier issues, all continuous independent variables except for GOVSCORE are winsorized at the top and bottom percentiles. We also tried an alternative method of controlling for potential outliers by deleting observations with R-student greater than the absolute value of 2. Our results remain quantitatively and qualitatively similar to those presented.

Table 4 The association between the discretionary accrual measure and corporate governance score based on three-category partitions for Gov-Score Panel A: Regression results based on three-category partitions Variable

Coeff. estimate

p-value

Coeff. estimate

p-value

Intercept HG MG FEERATIO NAS TENURE L1TA LNMV MB CFO LITIGATION LEVERAGE STDCFO BIG4 Industry dummies Year dummies Adjusted R2

0.0426⁎ − 0.0131⁎⁎⁎ − 0.0045 0.0094

0.0812 b.0001 0.1137 0.1240

0.0476⁎ − 0.0134⁎⁎⁎ − 0.0046⁎

0.0719 b.0001 0.1042

0.0044 − 0.0932⁎⁎⁎ − 0.0052⁎⁎⁎ 0.0014⁎⁎⁎ − 0.0725⁎⁎⁎ 0.0084⁎⁎ 0.0244⁎⁎⁎ 0.0418⁎⁎⁎ − 0.0210⁎⁎⁎ Yes Yes 0.2011

0.1189 b.0001 b.0001 b.0001 b.0001 0.0319 0.0011 b.0001 0.0004

0.0032 0.0042 − 0.0932⁎⁎⁎ − 0.0054⁎⁎⁎ 0.0014⁎⁎⁎ − 0.0722⁎⁎⁎ 0.0084⁎⁎ 0.0237⁎⁎⁎ 0.0419⁎⁎⁎ − 0.0212⁎⁎⁎ Yes Yes 0.20

0.2314 0.1444 b.0001 b.0001 b.0001 b.0001 0.0342 0.0009 b.0001 0.0003

Panel B: The incremental effect of Gov-Score on the absolute discretionary accruals β1 − β2 Significant Level

Model 1

Model 2

−0.0086⁎⁎⁎ 0.0056

−0.0088⁎⁎⁎ 0.0029

PMDACC ¼ β0 þ β 1 HG þ β 2 MG þ β 3 ðFEERATIO or NASÞ þ β 4 TENURE þ β 5 L1TA þβ6 LNMV þ β7 MB þ β 8 CFO þ β 9 LITIGATION þ β 10 LEVERAGE þβ11 STDCFO þ β 12 BIG4 þ ∑ β j INDj þ ∑ βk YEARk þ e j

k

⁎⁎⁎, ⁎⁎, ⁎ indicate significance level at ≤1%, 5%, 10% respectively. All continuous variables are winsorized at 1% and 99% to mitigate outliers. All variables are as defined in Table 1.

HG firms relative to that by MG firms). Panel B of Table 4 reports the results of the t-test, with the numbers in parentheses represent the twotailed p-values. In all cases, the difference (β1 −β2) is negative at the 1% significance level. These results suggest that firms characterized by strong corporate governance (HG firms) experience the greatest reduction in the absolute value of discretionary accruals (i.e. greatest improvement in earnings quality) relative to firms with weak corporate governance, while firms with medium level of corporate governance (MG firms) experience significantly smaller reductions. Thus, as firms strengthen their corporate governance, the quality of earnings tend to increase, but only those firms adopting strong corporate governance regimes achieve a significant improvement in earnings quality. These results provide additional insight into the relation between corporate governance and earnings quality. 5.3. Earnings benchmark tests As a robustness test of the ability of GOVSCORE to predict accounting discretion, we use “earnings surprise” as another surrogate to measure earnings quality. Burgstahler and Dichev (1997) examine the possibility that management may manage earnings to meet or beat analysts' forecasts slightly to project a smooth earnings path. They document a higher than expected frequency of slightly positive earnings surprises, consistent with earnings management to meet simple benchmarks such as analysts' forecasts. In this study, we use surprise to surrogate for lack of earnings quality. Using I/B/E/S data, we calculate earnings surprise as the difference between actual earnings per share (EPS) and the last available consensus mean forecast prior to the announcement of annual earnings. All EPS numbers are corrected for split adjustments. We then identify firms that just meet or beat analysts' expectations as those reporting a surprise of 0 or 1 cent. The measure of earnings surprise is an indicator variable equal to one if the firm just meets or beats expectations. We estimate the following regression models: Model 3. SURPRISE = β0 + β1 GOVSCORE + ∑ βj(Control Variablesj) + ε j

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Model 4. SURPRISE = β0 + β1 HG + β2 MG + ∑ βj(Control Variablesj) + ε j where SURPRISE is an indicator variable representing 1 if earnings meet or beat analysts' forecasts; 0 otherwise. All other variables are as defined earlier. We use a similar set of variables to control for incentives to meet or beat analysts' forecasts. Panel A of Table 5 provides descriptive statistics of the variables. The sample mean (median) Gov-Score has a mean (median) 26.8858 (26), with a standard deviation of 5.7445. These Gov-Score statistics resemble those from the sample used in the discretionary accruals analysis. The statistics for other control variables are also similar to those in panel A of Table 2, which indicates that the two samples are largely homogenous. Panel B provides the results of the logistic regression for Model 3. The results indicate a negative association between corporate governance and earnings surprise which is significant at the 5% level, consistent with firms with poor corporate governance being more likely to meet or slightly beat analysts' expectations. The coefficients on the control variables are, in general, statistically significant at one% level and have expected signs. Again, we find no significant association between the measure of auditor independence and earnings surprise. The results for Model 4 are reported in Panel C. The coefficient on HG is negative and significant at 5% while the coefficient on MG is negative but insignificant at conventional levels. The economic magnitude for the HG variable is nearly 3 times that of MG, implying that the probability of reporting a small earnings surprise is significantly higher for firms with strong corporate governance relative to firms with medium and weak governance mechanisms. Altogether, the findings from the earnings surprise regressions suggest that when corporate governance is lower, firms may have a greater tendency to engage in earnings management to meet or beat analysts' forecast, resulting in poorer quality of earnings. Lastly, we examine the association between corporate governance and the likelihood of firms reporting small earnings increases. Firms have incentives to report steadily increasing earnings and avoid reporting small declines in earnings (Burgstahler & Dichev, 1997). Following Ashbaugh et al. (2003), we compute increase in earnings as the annual change in net income scale by the beginning of year market value of common equity. A small earnings increase results if the scaled change falls in the interval [0.00, 0.02). Untabulated results reveal no statistically significant association between Gov-Score and small earnings increases. The differential results obtained from the two earnings benchmarks tests are consistent with the findings reported in Dechow, Richardson, and Tuna (2003). Dechow et al. (2003) document that the ratio of small profit firms to small loss firms and the ratio of firms reporting small earnings increases to those reporting small earnings decreases have declined during the 1988–2000 period, whereas the ratio of firms meeting or just beating analyst forecasts has strengthened considerably in the same period. Our results in Table 5 suggest that firms with weak corporate governance are more likely to use “meeting or beating analyst forecasts” as their vehicle of earnings management. 5.4. Additional tests In order to validate our results, we conduct several additional tests. First, to alleviate concerns that our results are driven by our accrual specification, we consider an alternative measure of abnormal accruals based on Dechow et al.'s (2003) forward-looking model: TAit ¼ α 1 þ β1 ½ð1 þ kÞΔREVit −ΔARit  þ β2 ½PPEit  þ β3 ½TAit−1  þβ4 ½GRSales it þ 1 þ eit

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Table 5 A logit regression analysis of the association between earnings surprise and corporate governance score Panel A: Descriptive statistics (n = 2969) Variable

Mean

STD

1st quartile

Median

3rd quartile

SURPRISE GOVSCORE FEERATIO NAS TENURE LNMV MB CFO LITIGATION LEVERAGE STDCFO BIG4

0.1432 26.8858 0.3451 0.3884 0.8218 6.8664 3.046 0.0732 0.3803 0.5051 0.1086 0.9579

0.3503 5.7445 0.2088 0.4875 0.3827 1.7759 3.6768 0.1504 0.4855 0.4978 0.1954 0.2009

0 22 0.1765 0 1 5.5796 1.4554 0.0323 0 0.2927 0.0303 1

0 26 0.3225 0 1 6.721 2.1347 0.086 0 0.2646 0.0586 1

0 31 0.4891 1 1 8.0817 3.5056 0.1492 1 0.6819 0.1088 1

Panel B: Association tests using GOVSCORE SURPRISE ¼ β 0 þ β 1 GOVSCORE þ β2 ðFEERATIO or NASÞ þ β3 TENURE þβ 4 LNMV þ β 5 MB þ β 6 CFO þ β 7 LITIGATION þ β8 LEVERAGE þβ 9 STDCFO þ β10 BIG4 þ ∑ β j INDj þ ∑ βk YEARk þ e j

k

Variables

Coeff. estimate

p-value

Coeff. estimate

p-value

Intercept GOVSCORE FEERATIO NAS TENURE LNMV MB CFO LITIGATION LEVERAGE STDCFO BIG4 Industry dummies Year dummies Pseudo R2 No. of OBS

− 1.4948⁎⁎⁎ − 0.0221⁎⁎ − 0.2350

0.0020 0.0443 0.4059

− 1.5770 ⁎⁎⁎ − 0.0193⁎⁎

0.0009 0.0497

0.1007 0.1429⁎⁎⁎ 0.0672⁎⁎⁎ 0.6408⁎ 0.2855⁎ − 0.9397⁎⁎⁎ − 2.4226⁎⁎ − 0.4169⁎ Yes Yes 0.1023 2969

0.5254 0.0005 b.0001 0.0825 0.0869 0.0009 0.0469 0.0692

0.0254 0.0984 0.1338⁎⁎⁎ 0.0674 ⁎⁎⁎ 0.6169⁎ 0.2890⁎ − 0.9537⁎⁎⁎ − 2.3450⁎ − 0.4271⁎ Yes Yes 0.1020 2969

0.8408 0.5356 0.0016 b.0001 0.0905 0.0842 0.0008 0.0539 0.0645

Panel C: Association tests using HG and MG SURPRISE ¼ β 0 þ β 1 HG þ β2 MG þ β3 ðFEERATIO or NASÞ þ β4 TENURE þβ 5 LNMV þ β 6 MB þ β 7 CFO þ β 8 LITIGATION þ β9 LEVERAGE þβ 10 STDCFO þ β11 BIG4 þ ∑ β j INDj þ ∑ β k YEARk þ e j

k

Variables

Coeff. estimate

p-value

Coeff. estimate

p-value

Intercept HG MG FEERATIO NAS TENURE LNMV MB CFO LITIGATION LEVERAGE STDCFO BIG4 Industry dummies Year dummies Pseudo R2 No. of OBS

−1.9226⁎⁎⁎ −0.2554⁎⁎ −0.0930 −0.2066

b.0001 0.0401 0.5096 0.4617

−1.9463⁎⁎⁎ −0.2270⁎⁎ −0.0812

b .0001 0.0382 0.5623

0.0908 0.1363⁎⁎⁎ 0.0665⁎⁎⁎ 0.6358⁎ 0.2990⁎ −0.9503⁎⁎⁎ −2.4221⁎⁎ −0.4091⁎ Yes Yes 0.1019 2969

0.5657 0.0007 b.0001 0.0843 0.0767 0.0008 0.0467 0.0731

0.0284 0.0895 0.1284⁎⁎⁎ 0.0668⁎⁎⁎ 0.6148⁎ 0.3006⁎ −0.9630⁎⁎⁎ −2.3504⁎ −0.4196⁎ Yes Yes 0.1017 2969

0.8222 0.5723 0.0021 b .0001 0.0919 0.0751 0.0007 0.0531 0.0685

SURPRISE = 1 if the firm meets or beats by one cent the mean analysts forecast, 0 otherwise. All other variables are as defined in Table 1. ⁎⁎⁎, ⁎⁎, ⁎ indicate significance level at ≤1%, 5%, 10% respectively. All continuous variables are winsorized at 1% and 99% to mitigate outliers.

where the slope coefficient from a regression of ΔARit on ΔREVit; firm i's total accruals from year t − 1, scaled by year t − 2 total assets; GR_Salesit + 1 the change in firm i's sales from year t to t + 1, divided by year t sales. k TAi

t−1

The forward-looking model makes three adjustments to the modified Jones model. First, rather than assuming all credit sales are discretionary, the model estimates the “expected” portion of the increase in credit sales, as represented by the slope coefficient k from

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the regression of ΔARit on ΔREVit. Hence, the models subtract the full amount of the change and adds back the expected change (which is k multiplied by the change in sales). Second, some proportion of total accruals is assumed to be predictable based on last year's total accruals. Thus, the lagged value of total accruals (TAi t − 1) is included to capture the predictable component. Third, the modified Jones model classifies increases in inventory in anticipation of higher sales as earnings management. Dechow et al. (2003) argue that such an increase in inventory balance is a rational one and, hence, includes a measure of future sales growth, (GR_Sales), to correct for such misclassifications. Thus, the forward-looking model uses future period data to estimate current period accruals. Dechow et al. (2003) provide empirical evidence that their model has higher explanatory power. When we re-estimate all of our regressions using the forward-looking measure,11 the results are qualitatively similar to those reported in the discretionary accrual analysis. Second, to assess whether our results are time sensitive or driven by any one year within our sample period, we re-run the analyses separately for each year. The respective sets of analyses produce results (untabulated) substantively the same as those reported for the full sample, except for year 2002, where the coefficient on GOVSCORE remains negative, but drops from significance in most cases. The 2002 sample period coincides with the Sarbanes–Oxley Act and changes in exchange listing requirements. Companies might have altered their governance mechanisms at some point during the year either in anticipation of or following these significant regulatory changes. The unstable governance structures might muddy the association between the measures of discretionary accruals and Gov-Score might be muddied, and reduce the power of our statistical tests. Third, since the results in our study may be confounded due to the range in the size of firms in our sample, we conduct two additional tests to investigate whether size affects our results. We first partition firms into quintiles based on their fiscal year-end total assets. In general, the inferences drawn from the results do not change. The statistical significance of the key variables remains significant at 1% across quintiles, although the overall results are somewhat weaker relative to those from the full sample, which is mostly likely due to the lower power of reduced sample size. In our second test, we restrict the sample to firms to having at least $100 million in total assets. Once again, the inferences are essentially the same as our initial analysis. Taken together, these two tests suggest that our results are not driven by the size effect. Fourth, to alleviate concerns that the incremental effects of GovScore are sensitive to the threshold cutoff used to classify firms into high, medium and low governance groups, we also test grouping schemes based on quartiles or quintiles. The results are inferentially similar to those in Table 4 when we rank the Gov-Score into four or five groups. More specifically, the reduction in discretionary accruals is most significant statistically and in magnitude for firms in the highest category, and we observe monotonically decreasing coefficients on the partitioning variables of Gov-Score ranked from low to high. However, when the quintile definition is used, the difference in incremental reduction between the highest and next highest category becomes only marginally significant. These results are consistent with only firms with a Gov-Score at or near the highest level experiencing a significantly greater reduction in discretionary accruals relative to other firms with weaker governance structures. Finally, Becker et al. (1998) find that companies with non-Big 5 auditors report discretionary accruals that significantly increase income compared to Big 5 auditors. In order to reduce the impact of lower earnings quality being attributed to lower audit quality and remove this bias, we restrict our sample to clients of Big 4 (in the post11 The Pearson correlation between PMDACC and the forward-looking measure is 0.5, indicating that the two measures to a large extent provide separate and distinct estimates of a firm's earnings quality.

SOX period). Results for these Big4 firms are almost identical to those for the full sample presented in Tables 5. 6. Summary and conclusions Currently, research examining the association of corporate governance to earnings quality has used various single measures of corporate governance such as auditor type, existence and composition of audit committees, and size of board of directors among others. However, corporate governance comprises many facets. No research to date has attempted to include all facets of corporate governance when examining this association. This study is the first to attempt to do so. We use the Gov-Score (Brown & Caylor 2006) as our corporate governance measure. After controlling for the effect of auditor independence, firm size, auditor tenure and size, financial health (as measured by operating cash flow and financial leverage), investor expectations (as measured by market to book ratio), firm risk (as measured by volatility in cash flows) and litigation risk, we find that there is a significant inverse relation between level of abnormal (discretionary) accruals and corporate governance. In particular, higher levels of corporate governance are associated with lower absolute values of discretionary accruals. Consistent with prior research, these results indicate that higher levels of corporate governance result in lower earnings management and improved quality of earnings. Our results are robust to alternative measures of discretionary accruals. When we partition firms into strong, medium and weak corporate governance groups, we find evidence that firms with strong corporate governance show considerably greater reduction in discretionary accruals as compared to other firms with medium or weak governance. This suggests that, in general, earnings quality tends to improve as firms strengthens corporate governance, but only firms with truly strong corporate governance regimes experience significantly improved quality of earnings. As a robustness test, we use, instead of discretionary accruals, earnings surprise as our dependent variable. Consistent with the conclusions from the discretionary accruals analysis, we find that firms with poor corporate governance are more likely to report earnings numbers that meet or slightly beat analysts forecast. This study lends itself to several opportunities for future research. Since the Gov-Score is not available for the companies in our sample prior to SOX, we could not conduct a pre and post analysis of the impact of SOX on earnings quality. This is a limitation of this study. An interesting line of research would include examining the association between earnings quality and corporate governance pre- and postSOX. This is one avenue for future research. Furthermore, Brown and Caylor (2006) created a parsimonious index based on seven provisions underlying Gov-Score that fully drive the relation between Gov-Score and firm value. Constructing a similar index in the context of earnings quality would allow us to identify a set of governance factors that are most significant in their impact on the quality of earnings.

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