Contemporary Accounting Research Vol. 22 No. 4 (Winter 2005) pp. 1093–122 © CAAA Audit Committees, Boards, and the Quality of Reported Earnings * NIKOS VAFEAS, University of Cyprus Abstract I use data on 252 U.S. firms between 1994 and 2000 to study the relationship between audit committees and boards of directors with financial reporting quality. I initially document several changes in committee and board profile during the sample period. Results from logistic regressions suggest that measures of audit committee and board structure are related to earnings quality in a manner that is generally consistent with the predictions of agency theory. This study contributes to extant knowledge by employing different earnings quality measures from prior studies, and by expanding the range of audit committee attributes deemed important in determining audit committee performance. Keywords Audit committee; Board of directors; Earnings quality JEL Descriptors G30, G38 Comités de vérification, conseils d’administration et qualité des résultats publiés Condensé Compte tenu du nombre croissant de scandales touchant l’information financière, le rôle des comités de vérification dans la gouvernance d’entreprise a fait l’objet d’un débat nourri chez les responsables de l’élaboration des politiques, les gestionnaires, les investisseurs et les uni- versitaires. Au cours des vingt dernières années, ce débat a engendré une série de rapports sur la gouvernance d’entreprise, prescrivant les structures souhaitables des comités de vérifica- tion, dont le plus récent est l’œuvre du Blue Ribbon Committee (BRC). Tous ces rapports s’articulent essentiellement autour d’un thème central : la possibilité pour les sociétés d’accroître la qualité de leurs états financiers en améliorant la structure et le fonctionnement de leurs comités de vérification. En outre, puisque la qualité des comités de vérification est fondamentalement liée à celle des conseils d’administration d’entreprise dont ils sont issus, les responsables de l’élaboration de politiques et les universitaires confèrent également à la structure du conseil d’administration une importance déterminante dans la qualité des états financiers. * Accepted by Michel Magnan. I have benefited from numerous useful comments and suggestions by Michel Magnan (associate editor), and two anonymous reviewers. Thanks also are due to Irene Karamanou for providing valuable input on a programming issue, Maria Christodoulou for competent research assistance, and First Call Corporation, a Thompson Financial Company, for pro- viding forecast financial data. This project was partly funded by a University of Cyprus research grant. 1094 Contemporary Accounting Research CAR Vol. 22 No. 4 (Winter 2005) La simple observation semble indiquer que les comités de vérification et les conseils d’administration présentent une grande variété transversale de structures et de modes de fonctionnement. Compte tenu de cette variété, la nature de la relation entre les structures du comité de vérification et du conseil d’administration et la qualité des résultats publiés (qualité des résultats dans la suite) est un sujet de recherche primordial dont les répercussions sur les politiques sont évidentes. Les données empiriques à cet égard confirment, pour la plupart, le point de vue selon lequel les comités de vérification et les conseils d’administration structurés de manière plus appropriée produisent de l’information de meilleure qualité en ce qui a trait aux résultats. Les chercheurs précédents ont démontré l’existence d’un lien entre les structures des conseils d’administration et des comités de vérification et les mesures de la qualité des résultats fondées sur la comptabilité d’exercice, les retraitements des états financiers et les propriétés des prévisions de résultats de la direction. La présente étude élargit ce champ de recherche en traitant du lien entre les attributs des comités de vérification et des conseils d’administration et deux variables substituts de la qualité des résultats : la probabilité que les sociétés évitent un fléchissement des résultats et la probabilité qu’elles préviennent des résultats négatifs inattendus. L’étude enrichit les con- naissances existantes de différentes façons. Premièrement, elle puise dans un bassin de recherche qui évolue à grands pas dans le domaine de la finance et qui met en lumière d’importantes différences dans les motivations, la capacité et la volonté des administrateurs externes de surveiller la direction. Le thème sous-jacent à ce champ de recherche veut qu’il soit trop simpliste de cibler l’indépendance des administrateurs et que d’autres facteurs puissent être liés à la performance d’un administrateur externe en matière de surveillance, notamment les incitatifs au rendement sous forme d’actions, les fonctions assumées au sein de conseils d’administration d’autres sociétés, la durée de l’appartenance au conseil d’admi- nistration, et les responsabilités dans d’autres comités. L’auteur avance l’existence d’un lien entre ces caractéristiques des administrateurs et la performance des comités de vérification, et il procède à l’examen empirique de leur relation avec la qualité des résultats. Deuxièmement, l’auteur s’abstient d’employer les mesures fondées sur les régularisations inhabituelles utilisées dans les travaux précédents — et auxquelles peuvent être associées des perturbations — en ayant recours aux faibles hausses des résultats et aux rendements négatifs inattendus pour évaluer la qualité des résultats. La qualité des résultats étant une notion difficile à cerner et aucune mesure ne s’étant véritablement démarquée par sa supé- riorité, l’adoption d’une autre perspective méthodologique pour définir la qualité des résultats, et pour produire des données complémentaires et corroboratives relativement à la question étudiée, est un autre aspect de l’intérêt que présente l’étude. Enfin, l’auteur emploie un échantillon constant de données, qui s’échelonnent sur sept ans, grâce auquel il peut analyser les questions pertinentes sur une période plus longue. Les données étant structurées sous forme d’échantillon constant, l’auteur soumet également à des tests les changements dans la gouvernance qui réduisent les risques d’omission de variables souvent présents dans les tests transversaux. L’étude des tendances chronologiques est également importante, car le débat sur la gouvernance d’entreprise et les réformes politiques qui en ont résulté dans les années 1990 ont entraîné d’importants changements dans les conseils d’administration et les comités de vérification d’entreprise. L’échantillon de l’auteur, qui couvre la majorité des années 1990, fait abstraction de l’hypothèse selon laquelle les structures de gouvernance restent inchangées dans le temps. Audit Committees, Boards, and the Quality of Reported Earnings 1095 CAR Vol. 22 No. 4 (Winter 2005) Les deux variables substituts de la qualité des résultats utilisées comme variables dépendantes dans la présente étude permettent de déceler les faibles hausses des résultats et les résultats inattendus. Les caractéristiques du comité de vérification et du conseil d’admi- nistration retenues par l’auteur sont les suivantes : pourcentage des membres du comité ayant un lien avec l’entreprise ; pourcentage des membres du comité assumant des fonctions de cadres dans d’autres sociétés ouvertes ; pourcentage des membres du comité siégeant aussi à un autre comité de vérification ; taille du comité de vérification ; nombre de réunions (annuelles) du comité de vérification ; fraction cumulative des actions ordinaires de l’entre- prise détenues par les membres du comité ; durée moyenne (en années) de l’appartenance des membres du comité au conseil d’administration ; nombre moyen de sièges occupés par les membres du comité dans d’autres conseils d’administration ; nombre moyen d’autres comités du conseil auxquels siègent les membres du comité de vérification ; pourcentage des actions ordinaires de l’entreprise détenues par l’ensemble des cadres et des administra- teurs ; pourcentage d’administrateurs externes ; taille du conseil d’administration. Enfin, le modèle englobe des contrôles relatifs aux pertes, au risque de litiges, à la taille de la société, aux actionnaires institutionnels et à la croissance de la société. L’échantillon initial de l’auteur est constitué de sociétés figurant au palmarès Fortune 500 de 1995. Les institutions financières et les sociétés de services publics sont retirées de l’échantillon du fait que le régime réglementaire particulier auquel elles sont soumises est susceptible d’influer sur le rôle des systèmes d’information financière dans le processus de gouvernance d’entreprise. Les sociétés à l’égard desquelles les données relatives à la gouver- nance et les données financières sont insuffisantes sont également retirées. L’échantillon définitif se compose de 1 621 observations relatives à 252 sociétés, pour la période 1994–2000. L’auteur estime deux équations de régression logistique qui relient la probabilité des deux mesures de la qualité des résultats aux structures du comité de vérification et du conseil d’administration. Pour tenir compte de la possibilité que les caractéristiques du comité de vérification et les pratiques de gestion du résultat soient en corrélation pour chaque société dans le temps, l’auteur adapte aux données un modèle des effets aléatoires. Ce dernier est estimé à partir de la totalité des 1 621 observations relatives aux 252 sociétés de l’échantillon. Les résultats de l’analyse semblent indiquer que les structures des comités de vérification et des conseils d’administration ont beaucoup évolué entre 1994 et 2000. Les conseils d’administration de sociétés sont maintenant de taille plus restreinte et sont plus indépendants. Les comités de vérification sont aussi plus indépendants et plus actifs, et ils comptent davantage de cadres et d’administrateurs siégeant aussi à un autre comité de vérification. Le total des actions de la société détenues par les membres du comité a également augmenté sensiblement. Cette transformation cadre généralement avec les pressions venant de la presse financière et les recommandations du BRC. Fait intéressant, la majorité de ces change- ments ont précédé les recommandations du BRC, ce qui donne à penser que maintes sociétés ont réagi par anticipation, peut-être pour détourner l’attention malvenue du public de la qualité de leur information financière et pour éviter les coûts politiques qu’aurait occasionnés cet intérêt. L’auteur recense donc les liens qui existent entre les structures des comités de vérification et des conseils d’administration et les faibles hausses des résultats de même que la prévention des résultats négatifs, les deux variables substituts de la qualité des résultats. Ses observations découlent de régressions logistiques multivariées expliquant la probabilité de faibles hausses 1096 Contemporary Accounting Research CAR Vol. 22 No. 4 (Winter 2005) des résultats et de la prévention des résultats négatifs. Des régressions des changements observés dans les conseils d’administration et les comités de vérification sur les indicateurs de qualité des résultats livrent d’autres données probantes à cet égard. En somme, la présente étude met au jour des récurrences empiriques qui élargissent l’éventail des explications relatives aux modalités de l’influence exercée par les comités de vérification et les conseils d’administration sur la qualité de l’information financière. Les facteurs tels que l’actionnariat des membres du comité de vérification, les fonctions assumées au sein d’autres comités et, à plus faible échelle, la durée de l’appartenance et les sièges occupés dans d’autres conseils d’administration semblent jouer un certain rôle dans l’explication de la qualité des résultats. Les conclusions de l’étude quant aux faibles hausses des résultats sont conformes à celles des travaux précédents. Les membres du comité de vérification ayant un lien avec l’entreprise sont associés à une qualité des résultats inférieure ; les membres du comité assumant des fonctions de cadres dans d’autres sociétés protègent la direction plus que les actionnaires ; et la fréquence des réunions du comité est associée à une qualité des résultats supérieure. L’auteur note, en outre, que le fait que des membres du comité siègent aussi à un autre comité de vérification est associé à une moindre occurrence de faibles hausses des résultats. Les observations relatives à la prévention des résultats négatifs inattendus se com- parent plus modérément aux conclusions des travaux précédents, puisqu’elles indiquent que l’augmentation des incitatifs au rendement sous forme d’actions et la durée de l’apparte- nance au conseil d’administration sont associées à une qualité des résultats inférieure. Dans leur ensemble, ces constatations pourraient être utiles aux responsables de l’élaboration des politiques qui envisagent des réformes de la gouvernance, aux gestionnaires et aux action- naires qui s’intéressent à l’amélioration de la qualité des états financiers, et aux chercheurs qui étudient la gouvernance d’entreprise et la qualité des résultats. Enfin, les conclusions de l’auteur paraissent indiquer qu’en général, au sens usuel, les comités de vérification et les conseils d’administration d’entreprise dont les structures et le fonctionnement sont appropriés peuvent contribuer à l’amélioration de la qualité de l’infor- mation financière. Les comités de vérification subissent actuellement d’autres changements d’importance, par suite des nouvelles règles adoptées par la SEC et les Bourses de valeurs. L’incidence à long terme de ces changements sur la qualité des états financiers des sociétés est une question qui mérite de retenir l’attention des chercheurs dans les années à venir. 1. Introduction Amid a growing number of financial reporting scandals, the role of audit committees in corporate governance has been the topic of an active debate among policymakers, managers, investors, and academics. Over the past 20 years, this debate fueled a series of corporate governance reports prescribing desirable audit committee struc- tures, the most recent by the Blue Ribbon Committee (BRC 1999). 1 The main theme running through these reports is that firms can improve the quality of their financial statements by structuring and operating their audit committees more appropriately. Moreover, given that the quality of the audit committee is funda- mentally linked to the quality of the corporate board from which the committee originates, policymakers and academics have also posited board structure as a determinant of financial statement quality (e.g., Pagano, Schwartz, Wagner, and Marinelli 2002). Audit Committees, Boards, and the Quality of Reported Earnings 1097 CAR Vol. 22 No. 4 (Winter 2005) Casual observation suggests that there is wide cross-sectional variation in the way audit committees and boards are structured and operate. Given such variation, the nature of the relation between audit committee and board structures and earn- ings quality is a fundamental research question with clear policy implications. The empirical evidence addressing this question has been mostly consistent with the view that more appropriately structured audit committees and boards produce earnings information of higher quality. Klein (2002), Xie, Davidson, and DaDalt (2003), and Bédard, Chtourou, and Courteau (2004) draw on BRC recommenda- tions addressing director independence and financial knowledge to document a link between board and audit committee structures with accruals-based measures of earnings quality. Abbott, Parker, and Peters (2004) similarly link audit commit- tee characteristics to financial restatements, and Larcker and Richardson (2004) find that corporate governance characteristics mitigate the relation between nonaudit fees and accruals. Finally, Karamanou and Vafeas (2005) document a relation between board and audit committee structures with the properties of management earnings forecasts. The present study extends this line of work by addressing the link between audit committee and board attributes with two alternative earnings quality proxies: the likelihood that firms avoid an earnings decline and the likelihood that firms avoid a negative earnings surprise. This study adds to extant knowledge in the following ways. First, it draws on a rapidly evolving body of research from the finance litera- ture that illuminates important differences in the incentives, ability, and will- ingness of outside directors to monitor management (e.g., Ferris, Jagannathan, and Pritchard 2003; Yermack 2004; Perry and Peyer, 2005). The underlying theme of this line of work is that a focus on director independence is overly simplistic, and that additional factors may be related to an outside director’s monitoring perform- ance, such as the director’s equity incentives, board seats in other corporations, length of board tenure, and other committee responsibilities. In this paper I propose a link between these director characteristics and audit committee performance, empirically examining their relation to earnings quality. Second, this paper abstracts from the potentially noisy abnormal-accruals- based measures used in prior studies by relying on small earnings increases and negative earnings surprises to measure earnings quality. Given that earnings quality has been an elusive concept to pin down, and that no single measure has emerged as definitively superior to others, using an alternative methodological perspective to capture earnings quality and to provide complementary and confirmatory evidence of the issue is also a potential contribution of this study. (In a similar spirit, recent studies by Leuz, Nanda, and Wysocki 2003 and Lang, Raedy, and Yetman 2003 use a variety of measures, in addition to accruals, to capture earnings quality.) Finally, this paper employs a seven-year panel of data that allows me to study the relevant issues over a longer time period. Given the panel structure of the data, I also per- form tests of changes in governance that reduce the likelihood of omitted-variables problems that are often present in cross-sectional tests. The study of trends over time is also important because the corporate governance debate and resulting pol- icy reforms of the 1990s have induced notable changes in corporate boards and 1098 Contemporary Accounting Research CAR Vol. 22 No. 4 (Winter 2005) audit committees. My sample, covering most of the 1990s, abstracts from the assumption that governance structures remain unchanged through time. Next, I develop the study’s research proposition. The remainder of this paper is organized as follows. Section 2 lays out the research proposition. I describe the measures of audit committee effectiveness and board structure in section 3. The data and methodology are discussed in section 4 and the results in section 5. Section 6 presents the summary and conclusion. 2. Research proposition Corporate boards in general, and audit committees in particular, are responsible for monitoring the information contained in financial reports. As suggested earlier, differences in board and audit committee structures across firms, coupled with dif- ferent levels of effectiveness of the various governance structures, suggest that the quality of board monitoring over financial reports is likely to vary across firms. Evidence addressing this notion empirically has clear policy implications. Out of equilibrium, evidence of higher earnings quality in firms with properly structured and functioning audit committees would justify policy efforts by those arguing that uniform committee structures be mandated. In contrast, lack of such evidence would be more consistent with an efficient contracting view of the firm, suggesting that reform may lead to monitoring that is redundant and costly because firms can choose an optimal mix of control mechanisms on their own. Motivated by these policy concerns, and building on earlier work, the present study addresses the link between audit committee structure and audit committee functioning with the quality of reported earnings empirically. Given that audit committees are the principal liaison between management and auditors and are chiefly responsible for reporting on earnings quality to the board of directors, I expect that their monitoring performance should partly determine the extent of earnings manipulation by managers. Moreover, the quality of the audit committee is fundamentally linked to the quality of the corporate board because all audit com- mittee members are also members of the board, and are appointed by the board itself, while audit committee decisions have to be ratified by the board as a whole. Accordingly, I also hypothesize that well-structured and functioning corporate boards are associated with improved financial reporting quality. To study the link between boards and audit committees with earnings quality, this paper considers two complementary measures of earnings quality, following Frankel, Johnson, and Nelson 2002 and Ashbaugh, LaFond, and Mayhew 2003. First, it focuses on the tendency of firms to manage earnings so as to avoid reporting a negative earnings change by isolating all firm-years with a marginally positive earnings change. This measure is based on prior evidence (e.g., Burgstahler and Eames 2003) that there is a discontinuity in the distribution of earnings changes around zero, suggesting that firms that report marginally positive earnings changes are likely trying to avoid reporting bad news to the market. The second measure is based on work by Matsumoto 2002, who suggests that firms try to meet analyst expectations benchmarks in order to avoid negative earnings surprises, apparently by managing earnings. These earnings quality measures have two potential Audit Committees, Boards, and the Quality of Reported Earnings 1099 CAR Vol. 22 No. 4 (Winter 2005) advantages over accruals-based measures: they are likely to be less noisy and incorporate the effect of cash flow manipulation. Extending this work, I suggest that the likelihood that a firm will report earnings of poor quality in order to avoid an earnings decline or a negative earnings surprise will be inversely related to the effectiveness of its audit committee and board of directors. R ESEARCH P ROPOSITION . The likelihood of reporting a marginal earnings increase or artificially avoiding a negative earnings surprise will be lower in firms with properly structured audit committees and boards of directors. 3. Measures of audit committee and board structure To measure audit committee effectiveness, I initially draw on the BRC recommen- dations to suggest a set of five audit committee characteristics that are likely to be related to audit committee performance. I then expand this set by examining the role of four additional audit committee characteristics and three general govern- ance characteristics that are likely to be associated with earnings quality. Audit committee characteristics highlighted by the Blue Ribbon Committee Monitoring the financial reporting process and ensuring high-quality financial statements is one of the prime tasks bestowed on corporate boards in general, and independent outside directors in particular. In line with this, the BRC report and prior evidence suggest that the presence of inside directors on the audit committee is likely to be related to poorer financial reporting choices (Klein 2002; Bédard et al. 2004), because insiders often have incentives to tolerate a lower quality of reported earnings. I therefore expect lower earnings quality in committees with insider participation. Second, the BRC recommends that all committee members be financially literate, and that at least one be a financial expert. Empirical evidence by DeZoort 1998, Xie et al. 2003, and Bédard et al. 2004 is consistent with the notion that committee member financial expertise enhances audit committee performance. Following Beasley and Salterio 2001, I suggest that business executives and directors who serve on the audit committee of another firm are likely to be financially knowledgeable, given that such knowledge is normally necessary for appointment to such positions. Conversely, it is possible that business executives are more likely to identify with, and thus befriend, management who underperform their monitoring role (DeZoort and Salterio 2001). Thus, ex ante, the link between earnings quality and business executives is undetermined, whereas a positive relation is expected between earn- ings quality and committee members with experience in other audit committees. A third potential determinant of audit committee performance is committee size. Ex ante, adding more directors to a committee is likely to have a nonlinear effect on committee performance. Initially, adding more members to the commit- tee enhances performance because there are more people on whom to draw. When committees grow too large, performance declines because of process losses and diffusion of responsibility. Reflecting concerns about understaffed committees, the BRC (1999) suggests that audit committees should have at least three members, to 1100 Contemporary Accounting Research CAR Vol. 22 No. 4 (Winter 2005) ensure a minimum required knowledge base and a lower likelihood that the com- mittee as a whole will be “handled” by management. Xie et al. (2003) find an insignificant relation between audit committee size and discretionary accruals. Given somewhat mixed predictions, I tentatively expect a positive relation between earnings quality and audit committee size. An important objective for audit committees is to provide their members with sufficient time to carry out their duties. Vafeas (1999) suggests that board meetings in general are a credible measure of board activity. Focusing on audit committees in particular, Menon and Williams (1994) and Xie et al. (2003) suggest that meetings are a reasonable proxy for committee effectiveness. In its sample audit committee charter, the BRC (1999) suggests that committees should hold at least four meetings per year. Accordingly, I expect that audit committees that meet more frequently also operate better, thereby leading to a higher quality of reported earnings. Additional audit committee characteristics One implicit assumption underlying research on audit committees to date has been that the monitoring performance of financially knowledgeable outside directors is more or less uniform. Committee members are assumed to perform similarly to one another provided that they are outsiders and have the financial knowledge to cope with the demands of audit committee service. The BRC report (1999) reinforces this view. Such research, however, can be enriched by a growing body of evidence from the finance literature highlighting other important differences among directors. This evidence suggests that, in addition to affiliation and knowledge, director perform- ance is likely to be related to equity incentives, total board seats, other committee service, and length of tenure on the board (e.g., Ferris et al. 2003; Yermack 2004; Perry and Peyer 2005). Drawing on this work, I posit the notion that these director characteristics, detailed below, will also be significant in evaluating audit commit- tees and explaining differences in performance across committee member directors and, ultimately, differences in performance across audit committees. The first such characteristic is audit committee member equity ownership. To align the interests of shareholders and outside directors, who are themselves agents of shareholders, firms routinely grant equity to outside directors. Yermack (2004) finds that director equity awards are made systematically, consistent with the predic- tions of agency theory. Moreover, there is growing evidence that outside directors who own more equity in the firm protect shareholder interests more effectively (for example, by reducing the likelihood of fraud litigation; see Ferris et al. 2003). In the context of audit committees, higher equity ownership by committee members is likely to reduce the danger of these directors colluding with management to manipulate earnings (for example, to inflate executive pay) because such collusion would ultimately harm their own interests as well. I therefore expect that the greater the fraction of equity that audit committee members own, the greater will be their motivation to monitor the financial reporting process more effectively, thus providing earnings information of higher quality. Second, director performance may be related to length of tenure on the board. There are two competing views on the impact of director tenure lengths on audit Audit Committees, Boards, and the Quality of Reported Earnings 1101 CAR Vol. 22 No. 4 (Winter 2005) committee effectiveness. More seasoned directors gain more experience and better knowledge about the firm’s operations and thus are able to exercise more effective decision control on management’s financial reporting choices than are junior, less experienced directors. In contrast, excessively lengthy board service might com- promise independence because senior directors may be more likely to befriend management (Vafeas 2003), becoming less critical of the quality of its financial reports (Beasley 1996). Yermack (2004) does not find a link between outside direc- tor turnover with either director tenure length or audit committee membership. Given conflicting predictions, the link between earnings quality and director tenure length is addressed empirically. The market for directorships provides corporate directors with a powerful incentive to perform their duties well. The more board seats directors hold, the more sensitive to reputation effects they are likely to be (e.g., Yermack 2004). News of poor audit committee performance, as conveyed by a financial reporting scandal, is likely to stigmatize the overseeing audit committee members, damaging their reputation and ability to acquire additional board seats. Furthermore, Ferris et al. (2003) do not find any evidence that holding more board seats compromises the directors’ monitoring performance in any way. Consistent with this finding, Perry and Peyer (2005) find that outside directorships by an executive enhance a firm’s value. I thus expect a positive relation between the average number of directorships held by audit committee members and earnings quality. Finally, additional committee service may have a bearing on director perform- ance in the audit committee. More committee service provides directors with greater knowledge of the firm’s affairs and more experience in monitoring manage- ment. Furthermore, appointment to a committee may signal a director’s ability to monitor management. Vafeas (1999) finds that firms that operate more board com- mittees also have more active and, presumably, more effective boards. Also, direc- tors who hold additional board seats, and thus have a greater reputation capital, serve at least as much as other directors in board committees (Ferris et al. 2003). Thus, I tentatively expect a positive relation between the number of other com- mittee memberships held by audit committee members and audit committee per- formance, as captured by earnings quality. General governance characteristics The fraction of shares owned by officers and directors as a group reflects the incen- tives the management team has to protect the interests of shareholders. Warfield, Wild, and Wild (1995) find that higher managerial ownership is associated with a greater information content of earnings, presumably because manager-shareholders secure better financial information for investors. I similarly expect that a greater fraction of insider ownership will be associated with higher earnings quality. Second, there is a vast body of literature suggesting that a greater proportion of outsiders serving on corporate boards is associated with improved board moni- toring over shareholders. Consistent with this notion, Beasley (1996), Dechow, Sloan, and Sweeney (1996), and Klein (2002) find that a higher representation of outside directors on the board is associated with higher financial reporting quality. 1102 Contemporary Accounting Research CAR Vol. 22 No. 4 (Winter 2005) I similarly expect the degree of board independence to be positively related to earnings quality. Finally, larger boards have been found to be associated with lower firm value because of the higher coordination costs and process losses they face (Yermack 1996). I also expect that larger boards make the monitoring process more difficult, thereby leading to financial reports of lower quality, and hypothesize that earnings quality is lower for firms with larger boards of directors. 4. Data and methodology The data My initial sample comprises firms that are listed in the 1995 Fortune 500 survey. Financial institutions (Standard Industrial Classification [SIC] codes 6000–6999) and utilities (SIC codes 4900–4999) are deleted from the sample, because their special regulatory environment is likely to influence the role of financial reporting systems in the corporate governance process. Also deleted are firms with no elec- tronic filings with the Securities and Exchange Commission (SEC) between 1994 and 2000, firms for which COMPUSTAT provides insufficient financial data for 1995, and foreign firms. This leaves a final sample of 252 firms. I extend the sample period one year before 1995 and five years forward, creating a seven-year panel of data from 1994 to 2000. Firms are allowed to exit the panel as they merge, go private or bankrupt, or otherwise cease to exist in their initial form, thereby limiting the effects of survivorship bias. Thus, the sample comprises an unbalanced panel of data over a seven-year period, ranging from 252 firms in 1995 to 182 firms in 2000, with a total of 1,621 firm-year observations. Information on audit committee and board structures is collected from the electronic filings of proxy statements with the SEC in EDGAR for each firm and each year. Financial information for each firm is collected from COMPUSTAT. Information on institutional holdings is collected from Compact Disclosure. Finally, information on analyst forecasts and on corresponding actual earnings per share (EPS) figures is collected from Institutional Brokers Estimate System (I/B/E/S). The two earnings quality proxies used as dependent variables in this study capture small earnings increases and earnings surprises. The audit committee and board characteristics employed are: percentage of committee insiders , percentage of active business executives , percentage of members with other audit committee experience , audit committee size , audit committee meetings , 2 stock ownership of committee members , mean tenure per committee member , mean directorships per committee member , mean committee memberships per committee member , 3 inside ownership , percentage of board outsiders , and board size . Finally, the model includes five control variables that are considered by both Frankel et al. 2002 and Ashbaugh et al. 2003: a loss dummy ; a litigation risk dummy ; firm size, proxied by equity capitalization ; institutional holdings ; and firm growth, proxied by the market- to-book ratio . (See the appendix for detailed definitions of the variables.) [...]... Market-to-book ratio Explanatory variables Lower earnings quality Undetermined Higher earnings quality Higher earnings quality Higher earnings quality Lower earnings quality Higher earnings quality Undetermined Higher earnings quality Higher earnings quality Higher earnings quality Higher earnings quality Lower earnings quality Higher earnings quality Lower earnings quality Lower earnings quality Lower earnings. .. consistent with the notion that the levels of, and changes in, some audit committee and board characteristics reduce the likelihood of poor earnings quality 6 Summary and conclusion In this paper, I address how the structure and activity of audit committees and the structure of corporate boards relate to the quality of earnings information produced by firms First, I find that audit committee and board structures... undergoing further significant changes as a result of new SEC and stock exchange rules The longterm impact of these changes on the quality of corporate financial statements is a question that deserves attention by academic research in the future CAR Vol 22 No 4 (Winter 2005) Audit Committees, Boards, and the Quality of Reported Earnings 1119 Appendix Measures of low earnings quality A small earnings increase.. .Audit Committees, Boards, and the Quality of Reported Earnings 1103 Methodology In sum, I estimate two logistic regression equations that link the likelihood of low earnings quality, approximated by the likelihood of a small earnings increase and the likelihood of meeting or just beating analyst expectations, respectively, using the following model: P(low earnings quality) = α 0 +... is the fraction of committee members who serve in the audit committee of another Fortune 500 firm over the sample period Audit committee size is the number of directors serving in the audit committee at fiscal year-end Audit committee meetings is the number of meetings held by the audit committee during the fiscal year Additional audit committee characteristics Stock ownership of committee members is the. .. length of committee member tenure on the board CAR Vol 22 No 4 (Winter 2005) Audit Committees, Boards, and the Quality of Reported Earnings 1121 References Abbott, L., S Parker, and G Peters 2004 Audit committee characteristics and restatements Auditing: A Journal of Practice & Theory 23 (1): 69–88 Ashbaugh, H., R LaFond, and B Mayhew 2003 Do nonaudit services compromise auditor independence? Further... above (below) the diagonal among variables approximating audit committee and board structure, and the likelihood of loss avoidance and negative surprise avoidance for 252 firms between 1994 and 2000 (n = 1,621) 1108 Contemporary Accounting Research Audit Committees, Boards, and the Quality of Reported Earnings 1109 TABLE 3 (Continued) Notes: A small earnings increase is a positive change of up to 2 percent... −3.80* 0.05 0.12 −0.05 0.11 0.07 −2.86 −0.01 −0.01 −0.20 −0.05 0.26 0.74 1998 1997 TABLE 5 Trend analysis of the relationship between audit committees, boards, and earnings quality measures Audit Committees, Boards, and the Quality of Reported Earnings CAR Vol 22 No 4 (Winter 2005) CAR Vol 22 No 4 (Winter 2005) 1996 252 248 −0.04 0.33 0.21 −0.29 −0.32† −0.18 0.33 −0.05 0.22† 0.11 −0.30† 0.06 243 −0.16 0.09... ownership is the percentage of common stock owned by of cers and directors as a group The percentage of board outsiders is the fraction of outside (non-executive) directors serving on the board Board size is the number of directors serving on the board at fiscal year-end Frankel, Johnson, and Nelson 2002 and Ashbaugh, LaFond, and Mayhew 2003 control variables The loss dummy is set to 1 for negative earnings. .. macro, and Littell, Milliken, Stroup, and Wolfinger 1996 for a description of the macro) The random-effects model illuminates how between-firm variation in boards and audit committees helps to explain poor earnings quality More specifically, the randomeffects model assumes that the slope coefficients are constant, while the intercept varies over individual firms and over time Also, the model assumes that the . holdings ; and firm growth, proxied by the market- to-book ratio . (See the appendix for detailed definitions of the variables.) Audit Committees, Boards, and the Quality of Reported Earnings. related to length of tenure on the board. There are two competing views on the impact of director tenure lengths on audit Audit Committees, Boards, and the Quality of Reported Earnings 1101 CAR . apparently by managing earnings. These earnings quality measures have two potential Audit Committees, Boards, and the Quality of Reported Earnings 1099 CAR Vol. 22 No. 4 (Winter 2005) advantages