davidson et al - 2005 - internal governance structures and earnings management

Accounting and Finance 45 (2005) 241–267 Internal governance structures and earnings management Ryan Davidson a , Jenny Goodwin-Stewart b , Pamela Kent a a UQ Business School, University of Queensland, St Lucia, 4072, Australia b School of Accountancy, Queensland University of Technology, Brisbane, 4001, Australia Abstract This paper investigates the role of a firm’s internal governance structure in constrain- ing earningsmanagement. It is hypothesized that the practice of earningsmanagement is systematically related to the strength of internal corporate governance mechanisms, including the board of directors, the audit committee, the internal audit function and the choice of external auditor. Based on a broad cross-sectional sample of 434 listed Australian firms, for the financial year ending in 2000, a majority of non-executive directors on the board and on the audit committee are found to be significantly asso- ciated with a lower likelihood of earnings management, as measured by the absolute level of discretionary accruals. The voluntary establishment of an internal audit func- tion and the choice of auditor are not significantly related to a reduction in the level of discretionary accruals. Our additional analysis, using small increases in earnings as a measure of earnings management, also found a negative association between this measure and the existence of an audit committee. Key words: Audit committee; Corporate governance; Earnings management; Internal audit function JEL classification: M40; M41 doi: 10.1111/j.1467-629x.2004.00132.x 1. Introduction Recent cases of inappropriate accounting practices, both in Australia and overseas, have focused attention on the need for strong corporate governance mechanisms. The authors acknowledge with thanks the helpful comments of two anonymous reviewers and the Associate Editor, Professor Stephen Taylor. We also thank Christine Jubb, Ping- Sheng Koh and participants at the 2003 Annual Conference of the Accounting and Finance Association of Australia and New Zealand, held in Brisbane, Australia. Financial support from the UQ Business School/KPMG Centre for Business Forensics and Queensland University of Technology is also gratefully acknowledged. Received 14 August 2003; accepted 29 April 2004 by Stephen Taylor (Associate Editor). C  AFAANZ, 2005. Published by Blackwell Publishing. 242 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 Strong governance involves balancing corporate performance with an appropriate level of monitoring (Cadbury, 1997). In the present paper, we explore the relationship between governance mechanisms and earnings management by firms in Australia and, hence, our focus is on the monitoring role of governance. The mechanisms we examine are an independent board of directors (Shleifer and Vishny, 1997), an independent board chairperson, an effective audit committee (Menon and Williams, 1994), the use of internal audit (Clikeman, 2003) and the choice of external auditor (Becker et al., 1998; Francis et al., 1999). Prior research has investigated the role of governance mechanisms in reducing fraudulent financial reporting (Beasley, 1996; Dechow et al., 1996; Jiambalvo, 1996). These studies have established a negative relationship between effective governance mechanisms and financial reporting decisions that are in breach of Generally Ac- cepted Accounting Principles (GAAP). However, a relatively new area of research is the association between corporate governance and earnings management. Peasnell et al. (2000) document that earnings management is negatively associated with the independence of the board of directors, while other studies find significant relation- ships between audit committee characteristics and earnings management (Chtourou et al., 2001; Xie et al., 2001; Klein, 2002a). The examination of the association between internal governance structures and the practice of earnings management in Australian firms is motivated by several factors. With the exception of Peasnell et al. (2000), which uses UK data, existing research is predominantly US based. Therefore, we explore whether the internal governance–earnings management relationship holds in an institutional environment where corporate governance is less regulated and choice of governance mechanisms is voluntary (Von Nessen, 2003). In Australia, at the time of the present study (2000), listed companies were not required to have an audit committee or an internal audit function. Furthermore, corporate regulators favour a principles-based approach to governance rather than a rules-based approach (ASX, 2003). Although a similar ap- proach exists in the UK, Peasnell et al. (2000) examine only the relationships between earnings management and the proportion of outside directors on the board and the existence of an audit committee. We extend this research by exploring the effect of additional audit committee variables such as size and frequency of meetings as well as the independence of members. We also extend board independence to examine whether the separation of the chief executive and board chair roles is associated with earnings management. A further contribution is the inclusion of internal audit as a governance mechanism that is likely to be associated with a reduction in the level of earnings management. While there has been increasing emphasis on the role played in governance by internal audit, no prior earnings management studies have included this variable. Australia is an ideal setting to examine this issue as evidence sug- gests that many listed companies in Australia do not have an internal audit function. Goodwin and Kent (2003) report that the use of internal audit is associated with the size of the company and its commitment to strong corporate governance and risk management. C  AFAANZ, 2005 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 243 Our principal tests, using absolute discretionary accruals to measure earnings man- agement, suggest that a lower level of earnings management is associated with the presence of non-executive directors on the board. We also find a negative associa- tion between earnings management and audit committees comprising a majority of non-executives, but no relationship between earnings management and committees comprised solely of non-executives. Our results do not support a relationship between earnings management and the use of internal audit or the choice of a Big 5 auditor. Additional testing, using small positive changes in earnings as an indication of earn- ings management, suggests that audit committees are associated with this measure of earnings management. These results have important practical implications because of the heightened interest in corporate governance matters from governments, regulators and standard setters. The remainder of the paper is divided into four sections. Section 2 provides the theoretical background for the study and develops the hypotheses. Section 3 outlines the research method used to test the hypotheses. It also discusses the measurement of earnings management through the estimation of discretionary accruals. Section 4 reports the present study’s results. Section 5 concludes by discussing the implications of the researchfindings, highlighting potential limitations and consideringfuture areas for research. 2. Theoretical background and hypotheses 2.1. Earnings management The preparation and disclosure of true and fair financial information is central to corporate governance, as it provides stakeholders with a foundation to exercise their rights, in order to protect their interests (OECD, 1999). However, earnings management, defined as: ‘the practice of distorting the true financial performance of (a) company’ (SEC, 1999, p. 3), effectively weakens this monitoring mechanism as it might conceal poor underlying performance. The published literature has developed and empirically tested a variety of moti- vations for earnings management to occur (Fields et al., 2001). These fall broadly within the categories of agency costs, information asymmetries and externalities af- fecting non-contracting parties. However, we are primarily concerned with the extent to which certain corporate governance attributes limit the opportunity to manage earnings, rather than specific incentives for earnings management to occur. Although we attempt to control for two widely documented motives for earnings management; namely, avoiding breaching debt covenants (Defond and Jiambalvo, 1991, 1994) and avoiding political costs (Watts and Zimmerman, 1978; Jones, 1991; Jiambalvo, 1996), our approach is to examine a broad cross-section of firms rather than identify- ing a specific subset with strong incentives to engage in earnings management. Such subsets of firms are often context-specific (e.g. recent managerial change, hostile takeover or new capital raising) and these contexts are likely to be endogenous to the internal governance mechanisms we examine. C  AFAANZ, 2005 244 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 2.2. Internal governance structure The internal governance structure of a firm consists of the functions and processes established to oversee and influence the actions of the firm’s management. The role of these mechanisms in relation to financial reporting is to ensure compliance with mandated reporting requirements and to maintain the credibility of a firm’s financial statements (Dechow et al., 1995). The mechanisms that we examine in the present study are the board of directors, the audit committee, the internal audit function and the choice of external auditor. 1 2.2.1. Board of directors Fama and Jensen (1983a,b) recognize the board as the most important control mechanism available because it forms the apex of a firm’s internal governance struc- ture. In terms of monitoring financial discretion, an effective board of directors should ascertain the validity of the accounting choices made by management and the financial implications of such decisions (NYSE, 2002). From an agencyperspective,the ability of the board to act as an effective monitoring mechanism is dependent upon its independence from management (Beasley, 1996; Dechow et al., 1996). Board independence refers to the extent to which a board is comprised of non-executive directors who have no relationship with the firm beyond the role of director. 2 A non-executive director is defined as a director who is not employed in the company’s business activities and whose role is to provide an outsider’s contribution and oversight to the board of directors (Hanrahan et al., 2001). A non-executive director who is entirely independent from management is expected to offer shareholders the greatest protection in monitoring management (Baysinger and Butler, 1985). Fama and Jensen (1983a,b) posit that the superior monitoring ability of non-executives can be attributed to the incentive to maintain their reputations in the external labour market. The published literature is supported by Australian and international corporate governance guidelines, which recognize the importance of the monitoring role of non-executive directors (AIMA, 1997, 1995; OECD, 1999; NYSE, 2002; ASX, 2003; Standards Australia International, 2003; Bosch Committee, 1995; Cadbury Committee, 1992). These guides suggest that best practice with respect to board 1 Another mechanism is the firm’s internal control system, but companies in Australia are not required to report on the strength of controls. We assume that external and internal au- ditors would ensure that controls are adequate. Furthermore, earnings management by senior management generally overrides controls that are in place. 2 According to the BRC (1999), audit committee members are independent if: (i) they, their spouses or children do not currently work or have not worked at the organization or its affiliates within the past 5 years; (ii) they have not received compensation from the organization or its affiliates for work other than board service; (iii) they are not partners, shareholders or officers of a business with which the organization has significant business. C  AFAANZ, 2005 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 245 composition is, at least, a majority of non-executive or independent directors. 3 This is supported by research evidence such as Beasley (1996), who finds that the presence of independent directors on the board reduces the likelihood of financial statement fraud, and Dechow et al. (1996), who report that firms with a greater proportion of non-executive directors are less likely to be subject to Securities and Exchange Commission (SEC) enforcement actions for violating US GAAP. Based on these findings, both Peasnell et al. (2000) and Chtourou et al. (2001) predict that board independence is also likely to be associated with a reduction in earnings man- agement. While Peasnell et al. (2000) find empirical support for their prediction with respect to UK firms, Chtourou et al. (2001) fail to find an association be- tween earnings management and board independence for a sample of US firms. Despite these conflicting results, we hypothesize a negative association between board independence and earnings management. Therefore, we test the following hypothesis: H 1a : Earnings management is negatively associated with the independence of the board of directors. Another important characteristic of boards is whether there is a separation of the roles of the chairperson and the Chief Executive Officer (CEO). While Arthur and Taylor (1993) point out that the underlying economic determinants of separating these roles are not well understood, corporate governance guidelines assume that a board’s ability to perform a monitoring role is weakened when the CEO is also the chairper- son of the board (e.g. Cadbury Committee, 1992; ASX, 2003; Standards Australia International, 2003). The appointment of the CEO to the position of chair can lead to a concentration of power (Beasley, 1996) and possible conflicts of interest, resulting in a reduction in the level of monitoring. This leads to the following hypothesis: H 1b : Earnings management is negatively associated with the separation of the roles of CEO and board chair. 2.2.2. Audit committee In order to more efficiently perform their duties, boards of directors might delegate responsibilities to board committees. In relation to monitoring the financial discretion of management, it is the audit committee that is likely to provide shareholders with the greatest protection in maintaining the credibility of a firm’s financial statements. This is because of the specialized monitoring of financial reporting and audit activities provided by the audit committee. 3 There has been a global increase in the demand for non-executives on the board because of the requirement for audit committee members to be independent. However, it is acknowledged that executive directors, with their in-depth knowledge of the business, also play an important role. Hence, the key is to find the appropriate balance with regard to board composition (Klein, 2002a,b). C  AFAANZ, 2005 246 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 In Australia, the Government’s Corporate Law Economic Reform Program (Au- dit Reform and Corporate Disclosure) Act 2004 (CLERP 9) (Commonwealth of Australia, 2004) proposes mandatory audit committees for the Top 500 listed compa- nies. Furthermore, the Australian Stock Exchange (ASX) amended its listing rules in 2003 to require any company that was included in the Standard and Poor’s 500/ASX All Ordinaries Index at the beginning of its financial year to have an audit commit- tee during that year. In addition, in March 2003, the ASX Corporate Governance Council released a best practice guide that recommends that all companies have an audit committee (ASX, 2003). However, in the year 2000, there was no requirement mandating audit committees. The only rule in place was that a listed company with no audit committee should disclose the reasons for this in a corporate governance statement in the company’s annual report. Prior published literature indicates that the effectiveness of an audit committee is dependent, in part, on the extent to which the committee is independent, its fre- quency of meetings and its size. 4 It is contended that audit committees are unable to function effectively when members are also executives of the firm (Lynn, 1996; BRC, 1999). Both the published literature and governance reports suggest that au- dit committees should consist exclusively of non-executive or independent directors (e.g. Menon and Williams, 1994; BRC, 1999; ASX, 2003). 5 This is supported by research that demonstrates a relationship between audit committee independence and a higher degree of active oversight and a lower incidence of financial statement fraud (Jiambalvo, 1996; McMullen and Raghundan, 1996; Wright, 1996). In contrast, how- ever, Klein (2002a) reports a negative relation between earnings management and a majority of independent directors on the audit committee, but finds no meaningful relationship between earnings management and an audit committee comprised solely of independent directors. To effectively monitor the financial discretion of management, the audit commit- tee is expected to review the financial reporting process, as well as to facilitate a flow of information among the board of directors, the internal and external auditors, and management (McMullen and Raghundan, 1996). However, both Cohen et al. (2000) and Gibbins et al. (2001) report that external auditors are sceptical of the role that audit committees play in reducing conflicts between auditors and management. Hence, to effectively discharge their responsibilities, audit committees need to be 4 It is recognized that other characteristics are also important indicators of an audit committee’s effectiveness. These include the financial literacy or expertise of the committee members (Kirk Panel, 1994; Goodwin and Yeo, 2001; Goodwin, 2003; ASX, 2003), the existence of an audit committee charter and the number of meetings held with the external auditor (BRC, 1999). However, as current disclosure requirements do not mandate such information, these variables cannot be tested using publicly available information. 5 The Corporate Governance Council recommends that all members of the committee should be non-executive directors, with a majority (including the chair) being independent. However, it acknowledges that international practice is for all members to be independent and it encourages companies to move towards such composition within the next 3 years (ASX, 2003). C  AFAANZ, 2005 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 247 active (Collier, 1993; Hughes, 1999) and to be of sufficient size (Cadbury Committee, 1992; CIMA, 2000). Audit committee activity has been operationalized through the number of committee meetings held during the financial year (Chtourou et al., 2001; Xie et al., 2001), with the expectation that the more often a committee meets, the more likely it is to carry out its responsibilities. Studies have found that the fre- quency of audit committee meetings is negatively associated with both earnings management, as measured by discretionary current accruals (Xie et al., 2001), and the likelihood of enforcement action by the SEC (McMullen and Raghundan, 1996). With regard to size, several corporate governance reports have proposed that the committee should consist of at least three members (BRC, 1999; NYSE, 2002; ASX, 2003). The existence of an effective audit committee provides a firm with an added layer of governance, which is expected to constrain earnings management behaviour. This leads to the following hypothesis. H 2 : Earnings management is negatively associated with the presence of an effective audit committee. 2.2.3. Internal audit function In addition to the audit committee, firms can voluntarily establish an internal audit function to supplement their existing internal governance framework. If established, this function provides firms with an assurance and consulting service, which can im- prove the effectiveness of their risk management, control, and governance processes (IIA, 1999). An internal audit function is also expected to facilitate the operation and effective functioning of the audit committee, as the goals of the audit function are closely aligned with the financial reporting oversight responsibilities of the audit committee (Scarbrough et al., 1998; Goodwin and Yeo, 2001; Goodwin, 2003). The formation of an internal audit function is endorsed by governance reports (NYSE, 2002) and prior literature (Collier, 1993; Goodwin and Kent, 2003) as a means of improving internal governance processes. Although traditionally internal audit has focused more on controls and operational risks, there has been increasing emphasis in the professional literature on the need to also focus on earnings management and inappropriate financial reporting (Eighme and Cashell, 2002; Martin et al., 2002; Rezaee, 2002; Clikeman, 2003; Hala, 2003). Sherron Watkins, former Enron vice president, believes that internal auditors should look for warning signs such as undue pressure from senior management to meet earnings targets and compensation arrangements that might encourage employees to manipulate earnings in order to receive financial rewards (Hala, 2003). Clikeman (2003) argues that internal auditors should not only be actively involved in detecting earnings management, but that they should take a proactive approach to educating managers and directors about the dangers of the practice. Eighme and Cashell (2002) regard the role of internal audit in detecting earnings management as being a com- plementary one to that of external audit. They believe that both should be actively C  AFAANZ, 2005 248 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 involved in the detection of inappropriate earnings management, thereby providing two unrelated opinions to the audit committee. These arguments suggest that the presence of an internal audit function should be associated with a lower level of earnings management. Accordingly, the following hypothesis is proposed. H 3 : Earnings management is negatively associated with the presence of an internal audit function. 2.2.4. External audit The choice of a firm’s auditor is another internal governance mechanism that is likely to be associated with earnings management. Research evidence suggests that the large audit firms are perceived to perform higher quality audits than smaller audit firms (DeAngelo, 1981). While examples such as Enron in the USA and HIH in Australia might suggest otherwise, the large firms are considered to be more effective monitors of the financial reporting process compared to smaller firms (Francis et al., 1999; Francis and Krishnan, 1999; Kim et al., 2003). Krishnan (2003) argues that, not only do the large audit firms have more resources and expertise to detect earnings management, but they also have a greater incentive to protect their reputation because of their larger client base. Past studies demonstrate that clients of Big 5 auditors report lower levels of earnings management than clients of non-Big 5 auditors (Becker et al., 1998; Francis et al., 1999). 6 Therefore, we expect that firms that choose a Big 5 auditor are less likely to engage in earnings management. This gives rise to the following hypothesis: H4: Earnings management is negatively associated with the use of a Big 5 auditor. 3. Research design The present study involves a cross-sectional analysis of 434 firms listed on the ASX for the financial year ending in 2000. To test our hypotheses, we use two primary models which regress absolute discretionary accruals on a set of governance and control variables. The two models differ only in their measure of audit committee independence. We also conduct additional tests, using alternative measures of both the dependent variable and a number of independent variables. 3.1. Sample selection Our preliminary sample of 568 firms comprised companies for which annual reports were available either on the Connect4 database, on company websites or in hard copy. Financial information and information pertaining to boards of directors and audit committee characteristics were obtained from disclosures made in annual 6 For the reporting period ending in 2000, there were five main audit firms (the Big 5). C  AFAANZ, 2005 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 249 reports. However, annual report disclosure concerning the use of internal audit is not mandatory. Therefore, this information was obtained by one of three methods. The first method involved consulting the University of Queensland/KPMG Centre for Business Forensics database. 7 The second method involved examining annual report disclosures. 8 The final method involved directly contacting firms, which were either not included on the database or whose annual reports made no mention of an internal audit function. To arrive at the final sample, exclusions were made on the basis of industry classification and insufficient governance or financial information. For the purpose of industry classification, the Global Industry Classification Standard (GICS) was adopted. 9 Firms were classified according to the 59 GICS industries and, consistent with prior research, industries with less than 8 firms were eliminated. Firms in the financial sector were also excluded because of their unique working capital structures (Klein, 2002a) and the added layer of governance imposed through regulation (Barn- hart et al., 1994). Those firms with missing financial or governance information were also excluded, as were 4 firms with extreme values for discretionary accruals. 10 After these exclusions were made, the sample for the study was limited to 434 firms in 24 industries. 11 Table 1 presents a breakdown of the sample according to GICS sector, showing the broad cross-section of firms included within the sample. 3.2. Measurement of the variables 3.2.1. Earnings management The published literature has developed several tests of earnings management, in- cluding the assessment of accounting policy changes (Healy, 1985; Sweeney, 1994), specific accounting transactions (McNichols and Wilson, 1988), discretionary accru- als (Jones, 1991) and small profits or small changes in earnings (Holland and Ram- say, 2003). The present study uses discretionary accruals as the primary measure of 7 This database comprises information on 464 firms that responded to a survey sent to all firms listed on the ASX in 2000. The survey included a question concerning the use of internal audit. Approximately 65 per cent of the final sample was generated from this source. 8 Firms were recorded as having an internal audit function when the words ‘internal audit’ were contained within the annual report. Approximately 20 per cent of the final sample provided this information in their annual reports. 9 The GICS classification structure consists of 10 broad economic sectors aggregated from 23 industry groups, 59 industries and 122 sub-industries. The present study adopts the GICS structure as it has become the new industry classification scheme of the ASX since 1 July 2002. 10 These firms had discretionary accruals divided by lagged assets of 1.5 or more and tests revealed that they could be considered to be outliers. 11 From the original 568 firms, 48 were in industries with less than 8 firms, 58 were in the financial sector and 24 had missing data, giving 438 firms before excluding the four outliers. C  AFAANZ, 2005 250 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 Table 1 Analysis of sample by GICS sectors and industries Sector Industry Industry Sample Sample ASX a (number) code (%) (%) Energy Oil & gas (2) 101010 23 5.30 4.47 Materials Chemicals (3) 151010 8 32.26 24.76 Construction materials (4) 151020 8 Metals & mining (6) 151040 116 Paper & forest products (7) 151050 8 Industrials Building products (9) 201020 9 12.44 12.58 Construction & engineering (10) 201030 14 Industrial conglomerates (12) 201050 15 Commercial services & supplies (15) 202010 16 Consumer Auto components (21) 251010 8 17.97 12.25 discretionary Hotels, restaurants & leisure (26) 253010 23 Media (27) 254010 31 Specialty retail (31) 255040 16 Consumer Beverages (33) 302010 15 8.29 5.22 staples Food products (34) 302020 21 Health care Health care equipment & supplies (38) 351010 9 5.76 7.28 Health care providers & 351020 8 services (39) Pharmaceuticals (40) 352010 8 Financials Real estate (45) 404010 25 5.76 18.05 Information Internet software & services 451010 8 6.45 11.17 technology Software electronic 451030 12 Equipment & instruments 451030 8 Telecommunication Diversified telecommunication 501010 17 3.92 3.06 Services Services (54) Utilities Electric utilities (56) 551010 8 1.84 1.16 Total 434 100 100 a Based on 1218 listed entities, as of 31 March 2002. ASX, Australian Stock Exchange; GICS, Global Industry Classification Standard. earnings management while we also use small profits and small changes in earnings in our additional analysis. Earnings management research has been dominated by studies that have followed the general discretionary accruals framework proposed by McNichols and Wilson (1988). This framework partitions accruals into non-discretionary and discretionary components on the assumption that a high level of discretionary accruals (DAC) suggests that a firm is engaging in earnings management. The most frequently used method to decompose accruals is the modified-Jones model (Dechow et al., 1995). This model assumes that the non-discretionary component of total accruals (NDAC) is a function of the change in revenues adjusted for the change in receivables and the level of property, plant and equipment, which drive working capital requirements and depreciation charges, respectively. C  AFAANZ, 2005 [...]...R Davidson et al / Accounting and Finance 45 (2005) 241–267 251 We use the cross-sectional version of the modified-Jones model (DeFond and Jiambalvo, 1994; Becker et al. , 1998; Bartov et al. , 2000) Under this model, the level of discretionary accruals for a particular firm is calculated as the difference between the firm’s total accruals and its non-discretionary accruals (NDAC), as estimated... corporate governance variables are statistically significant C AFAANZ, 2005 262 R Davidson et al / Accounting and Finance 45 (2005) 241–267 Next, we explore the possibility that firms reporting small increases in earnings or small profits might have achieved their results by engaging in earnings management We plot histograms of earnings and changes in earnings, following Holland and Ramsay (2003) Although... partner, and 0 otherwise SUBSH (substantial shareholder) = the percentage of shares held by the largest ‘substantial shareholder’ LEV (financial leverage) = total liabilities divided by total assets ABSCH (absolute change in net income) = the absolute change in net income between t and t − 1 divided by total assets SIZE (firm size) = natural log of total assets MKT (market to book ratio) = the market value... partner, and 0 otherwise SUBSH (substantial shareholder) = the percentage of shares held by the largest ‘substantial shareholder’ LEV (financial leverage) = total liabilities divided by total assets ABSCH (absolute change in net income) = the absolute change in net income between t and t − 1 divided by total assets SIZE (firm size) = natural log of total assets ABSNI (absolute net income) = the absolute net... to this cut-off point Another set of tests addresses concerns relating to the high correlation coefficients between the audit committee variables First, we re-perform the regression analyses 19 Qualitatively similar results are achieved when absolute change in net income and absolute net income are scaled by beginning total assets C AFAANZ, 2005 R Davidson et al / Accounting and Finance 45 (2005) 241–267... associated with earnings management and positively associated with audit committee and board independence and the use of internal audit (Bartov et al. , 2000; Klein, 2002a; Goodwin and Kent, 2003) Following Klein (2002a,b), absolute current earnings (ABSNI), measured by the absolute value of net income before extraordinary items scaled by total assets, is also included;16 as is the market to book ratio... partner, and 0 otherwise SUBSH (substantial shareholder) = the percentage of shares held by the largest ‘substantial shareholder’ LEV (financial leverage) = total liabilities divided by total assets ABSCH (absolute change in net income) = the absolute change in net income between t and t − 1 divided by total assets SIZE (firm size) = natural log of total assets ABSNI (absolute net income) = the absolute net... relationship between the audit committee and the internal audit function: evidence from Australia and New Zealand, International Journal of Auditing 7, 263– 276 Goodwin, J., and P Kent, 2003, Factors affecting the voluntary use of internal audit, Working paper (University of Queensland, St Lucia/Queensland University of Technology, Brisbane) Goodwin, J., and T Y Yeo, 2001, Two factors affecting internal audit... analysis focuses on absolute discretionary accruals as a proxy for earnings management This measure is non-directional, capturing both upwards and downwards earnings management Therefore, we conduct additional tests that focus only on upwards earnings management First, we re-run our prior tests using signed discretionary accruals as the dependent variable Although we obtain qualitatively similar results... Cash-flow approach: TAC = EBXI − CFO Where: EBXI = earnings before extraordinary items (net t t t t of taxes) for period t and CFO t = cash flow from operations for period t Discretionary accruals (DAC) are estimated by subtracting the predicted level of non-discretionary accruals (NDAC) from total accruals, as calculated under the cash-flow approach (standardized by lagged total assets) TAC ijt = total . endogenous to the internal governance mechanisms we examine. C  AFAANZ, 2005 244 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 2.2. Internal governance structure The internal governance. governance and risk management. C  AFAANZ, 2005 R. Davidson et al. / Accounting and Finance 45 (2005) 241–267 243 Our principal tests, using absolute discretionary accruals to measure earnings man- agement,. relation- ships between audit committee characteristics and earnings management (Chtourou et al. , 2001; Xie et al. , 2001; Klein, 2002a). The examination of the association between internal governance