Outside directors and their influence on earnings management : an analysis

Outside directors and their influence on

earnings management: an analysis

Full name: Bryan Kelder

Student card number: 10180524 Date of submission: 30‐06‐2014 Version of the thesis: Final version BSc accountancy and control University of Amsterdam Supervisor: Mario Schabus

Abstract

The main objective of this paper is to investigate what the proportion of outside directors on a board is on the extent in which earnings management persists. It also tries to separate this objective in two forms of boards, namely the one-tier board and the two-tier board. The several accounting scandals and frauds by the management of several firms have increased the importance for sound corporate governance. Also, there have not been many literature reviews that address this topic; therefore, it is interesting to do research on this topic. To accomplish this, this paper uses the form of a literature review as research method to analyze the relevant literature that has been written on this topic. From the literature available, this paper has found that earnings management in the form of within-GAAP earnings

management and non-GAAP earnings management is reduced if there is a higher proportion of outside directors on a one-tier board. Moreover, there was found that earnings

management in the form of real transaction management increases, if there is a higher proportion of outside directors on a one-tier board. However, there were mixed results with regard to the two-tier board and the literature that focused on this sort of board. This can be contributed to the fact that there has been little research on countries that use a two-tier board in their corporate governance models. Therefore, it is suggested that research should focus more on studies in these countries. Outside directors contribute to the integrity of the financial statements, but their lack of insider knowledge makes it harder to detect real

transaction management, thereby substituting one form of earnings management for another.

Samenvatting (summary in Dutch)

De hoofddoelstelling van deze paper is om onderzoek te doen naar de proportie van onafhankelijke commissarissen in een raad en daarbij te kijken hoe dit earnings management beïnvloedt. Deze doelstelling wordt bekeken vanuit een perspectief van een one-tier board en een two-tier board. De verschillende schandalen en fraudes die zijn gepleegd met betrekking tot de jaarverslagen door verschillende bedrijven, heeft de mate waarin corporate governance belangrijk wordt geacht, verhoogd. Ook zijn er weinig literatuurstudies uitgebracht die zich op dit onderwerp focussen. Daarom is het interessant om onderzoek te doen naar dit

onderwerp. Met behulp van de wetenschappelijke literatuur die beschikbaar is, is gebleken dat earnings management in de vorm van within-GAAP en non-GAAP earnings management werd verlaagd als er een hogere proportie onafhankelijke commissarissen op een one-tier board zaten. Daarnaast is er gevonden dat earnings management in de vorm van real

transaction management werd verhoogd als er een hogere proportie onafhankelijke

commissarissen op een one-tier board zaten. Maar er waren tegenstellende resultaten in de wetenschappelijke literatuur die te maken hadden met het onderwerp van deze paper en het two-tier board. Dit kan worden verklaard doordat er weinig onderzoek is geweest, die zich focust op landen waarin een systeem met ene two-tier board wordt gebruikt. Daarom wordt er gesuggereerd dat onderzoek zich meer zou moeten focussen op deze landen. Over het

algemeen dragen onafhankelijke commissarissen bij aan de integriteit van jaarverslagen in landen waar one-tier boards worden gebruikt. Maar deze commissarissen hebben over het algemeen minder insider kennis waardoor het moeilijker wordt voor hen om real transaction management op te merken en daardoor wordt een vorm van earnings management

ABSTRACT

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SAMENVATTING (SUMMARY IN DUTCH)

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1. INTRODUCTION

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2. LITERATURE REVIEW

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3. OUTSIDE DIRECTORS AND THEIR CHARACTERISTICS

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4. ANALYSIS

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5. CONCLUSION

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Outside directors and their influence on earnings management: an analysis

1. Introduction

In past years, society has encountered vast fraud and accounting scandals. In the early years of the 21th century, there have been scandals involving companies such as Enron, and Worldcom. Furthermore, the world has experienced the worst financial crisis since the 1930s, starting from 2007. One of the contributing factors that started the financial crisis were certain incentives that did not align the interests of parties in a business relationship (Hull, 2012). Certain employees who were in senior positions were compensated in the form of an annual bonus, which was a big part of their annual salary. These bonuses were paid out based on some kind of short term performance measure such as profits at the end of the year. This structure caused senior employees to focus on short term profits instead of focusing on long term profits and sustainability of profits. These occurrences dried out equity markets and sent a lot of investors searching for safer investments to invest their money in. It also damaged the trust that investors had in the equity market, learning that senior management had a lot to do with these frauds.

Management is responsible for adopting sound accounting policies, maintaining adequate internal control and making fair representations in the financial statements (Arens, Elder, Beasley, & Hogan, 2014). However due to fraudulent reporting, the management of several companies around the world has been accused of managing earnings, which is defined as: “the practice of distorting the true financial performance of (a) company” (SEC, 1999).

This caused society to become more interested in the issues in corporate governance. Corporate governance can be defined as: the system of rules, practices and processes by which a company is directed and controlled (corporate governance definition, n.d.). According to Fields & Keys (2003), “Corporate governance issues, once a matter for

discussion only in boardrooms and academic venues, have emerged from Wall Street to Main Street”. Firms and regulators responded to society by implementing changes which would restore the confidence of the investors.

Amongst these changes, were changes that would increase the independence of decisionmaking in firms. The frauds and scandals together with the increase in size of cooperations, creating an information assymetry between shareholders and managers (Klein, 1998), increased the call for independence. One of the ways that firms decrease information assymetry is by implementing a board of directors which is one of the major functions in a

firm that mitigates the agency conflicts between shareholders and management by monitoring management and thus decreasing the information assymetry (Klein, 1998).

It seemed that this was not enough, and so a number of reports have proposed ideas for changes that would result in an even greater independence of decisionmaking. Such as the report that was issued by the National Association of Corporate Directors which was named: Report of the NACD Blue Ribbon Commission on Director Professionalism (Fields & Keys, 2003). The report makes several recommendations on important concerns related to corporate boards, namely that the board should include a significant portion of directors who are

independent. A way to achieve this is to include outside directors on the board, because these directors are more independent than inside directors (NCAD Blue Ribbon Commission, 2005). The difference between an outside director and an inside director is that the latter is an employee, officer, or stakeholder in the company, while the other is not. Several other reports, pertaining to corporate governance isssues, made similar recommendations (Fields & Keys, 2003).

Some research has shown that the proportion of outside directors on the board is negatively correlated with earnings management, because it was found that it impacts abnormal accruals which are a proxy for earnings management (Krishnan, 2005). In other literature, this connection does not seem to hold. Research by Park & Shin (2004) found that outside directors, as a whole, do not reduce earnings management. On the other hand, directors from financial intermediaries seemed to reduce earnings management, which is consistent with the recommendations from the NCAD; recommending that directors should be financially illiterate. This seems to suggest that financial knowledge is an important asset for a director, but what about the effect of insider knowledge, as outside directors could be less effective if they lacked this knowledge? Some research suggests that this knowledge for outside directors to be efficient (Adams, Hermalin, & Weisbach, 2010).

The purpose of this paper is to investigate what the influence of the proportion of outside directors on a board is on earnings management, so the following question will be proposed in this paper: what is the influence of the proportion of outside directors on a board on earnings management? This research question will be answered by looking at two kinds of board: a one-tier board and a two-tier board.

The method that will be used for investigating this question is a literature review, where prior literature surrounding this subject will be subjected to analysis and critisism. To investigate whether outside directors have an influence on earnings management, this paper

will look at several measures that researchers use to measure earnings management, which will be explained further in this paper.

The contribution of this paper is that it summerizes and analyses preceding literature on the topic of outside directors’ influence on earnings management. This is useful for academic purposes, because prior literature has shown results that are not consistent or even opposing and therefore a summary and comparison is useful. Secondly, there have not been a lot of papers that have done this. Thirdly, the results of this study could potentionally be of importance to legislators and the capital market as a whole, because this study clarifies the role of the board as determinant of earnings management. Finally, this study shows that there is insufficient research on the topic of the proportion of outside directors on a two-tier board and their influence on earnings management. Therefore, this study contributes by showing this, and can be useful to signal researchers to investigate this area.

The main findings of this paper can be summarized in these words: on a one-tier board it is shown that, on average, the proportion of outside directors on a board negatively influences the extent in which Non-GAAP and within-GAAP accrual earnings management persists, while it positively influences the extent in which real transaction earnings

management persists. On a two-tier board, it is shown that there are mixed results with respect to the proportion of outside directors on a board influences the extent in which earnings are managed.

2. Literature review 2.1 Earnings management

A firm’s financial statements summarize the economic consequences of its business activities. These financial statements are prepared by the management of a firm as they are the ones responsible for the preperation of the financial statements. This suggests that managers have an influence over the financial statements. It is even predicted that managers may choose to achieve a certain goal with respect to a level of earnings that they want to meet, which is called earnings management. A definition of earnings management is the following: the choice by a manager of accounting policies, or actions affecting earnings, so as to achieve some specific reported earnings objective.

Several theories expect that managers will use earnings management to their advantage, sometimes at the expense of the firm. Healy focused on the effect of bonus

firm with bonus plans that are based on earnings will maximize current earnings to maximize their short-term compensation (Healy, 1985). Healy proposed that these bonus plans worked according to rules specified by the contract. He collected these details from the data set which he obtained. Firstly, there was a certain point at which the bonus would be paid out, which he called the bogey, and secondly, the bonus would linearily increase towards a certain point as a function of earnings, untill the bonus crossed a point where the bonus would no longer increase, called the cap. Based on the hypothesis, Healy expected that if earnings would be above the cap or below the bogey, then earnings would be managed downward and if earnings would be between the bogey and the cap, that earnings would be managed upward. He used data that he obtained from firms, but Healy did not have full access to all the information about discretionary accruals, which are used as a measure for earnings

management. Because of this, Healy assumed that non-discretionary accruals were constant and by doing this he could use the full accruals as a proxy (1985). Firstly, he gathered data which included data necessary to calculate the bogey and the cap of the bonus plans and other financial data. Secondly, he divided the data into three categories: observations where

earnings were below the bogey, observations where the earnings fell between the bogey and the cap and observations where earnings were above the cap. He found that for the

observations that were above the cap and for observations that were below the bogey, that the accruals were income-decreasing. This means that earnings are being managed downward in order to have a bigger chance of receiving a bonus next year. There will be a bigger chance to receive a bonus next year, because of a law that follows discretionary accruals. This law says that the managing of earnings that can not be sustained must be reversed in the next year, which means that earnings will go up in that next year, increasing the chance of a bonus. Furthermore, he found that the average accruals were income-increasing with the

observations that fell between the bogey and the cap, suggesting that managers manage their earnings upward to receive a higher bonus now. Therefore, he concluded that his empirical results showed that managers managed earnings to increase their bonuses and consequently that earnings management existed.

However, Healy’s research is subject to methodological problems that existed because of his data and of the use of his particular model. Healy used a proxy to capture discretionary accruals, namely total accruals; thereby introducing a measurement error. According to Dechow, Sloan, and Sweeney, most models stated that total accruals consists of non-discretionary accruals and non-discretionary accruals (1995):

Total accruals = Non-discretionary accruals + discretionary accruals

And to say that non-discretionary accruals are constant is a major simplification of reality. Total accruals can be obtained by looking at the difference between accounting earnings and the cash flows from operations. However, it is difficult to estimate the non-discretionary accruals, and therefore it is difficult to estimate discretionary accruals which is used as a proxy for earnings management. Healy assumed that total accruals was equal to non-discretionary accruals, because he used a two-period model in which the non-discretionary accruals would cancel themselves out over the two periods.

Later studies used other data and more refined ways to capture discretionary accruals. Holthausen, Larcker, and Sloan (1995) improved on Healy’s study by obtaining data which showed more information about the bonus structure. They could now determine if the bonus was nil, greater than nil or at its maximum, while Healy had to estimate the bonus for the manager which he based on descriptions of bonus contracts. Moreover, Jones (1991) improved on the methodology by introducing the Jones model for estimating discretionary accruals, in which Jones controls for business activity.

With these improvements in data and methodology Holthausen, Larcker and Sloan (1995) use a modified Jones model to do a study on annual bonus schemes and the

manipulation of earnings by managers. They used a modified Jones model, because the Jones model creates a bias in the model when credit sales are acknowledged. When a credit sale is made, the accounts receivable increases, as does the total revenue, creating a diminishing effect on accruals. That is why they included the variable accounts receivable to remove this bias. Their results were similar, but with one exeption; they found that earnings that were below the bogey did not lead to managers managing the earnings down. They found that managers managed their earnings upward if the earnings were between the bogey and the cap, similarly to Healy’s study. However, they found that if earnings were below the bogey, then the earnings would not be managed downward to increase the chance to earn a bonus next year. They showed that this difference in results can be contributed to the methodological problems which Healy’s method of research was subjected to.

Furthermore, research on earnings management is still subjected to problems which are imposed on the studies by the methodology used for this research. According to Wahlen & Healy (1999), it suffers from two problems, namely: that reseachers do not have access to information which describes the managers’ incentives for reporting earnings and that they can not perfectly quantify by how much the discretionary accruals have influenced the earnings.

This means that reseachers can never perfectly measure earnings management, and therefore they must use a model for it (i.e. they have to estimate the discretionary and

non-discretionary accruals). But all in all, there is significant evidence that, on average, managers use earnings management for various reasons (Wahlen & Healy, 1999).

From the preceding definition of earnings management, it is clear that there are two ways in which earnings management can be achieved. Firstly, a manager has a choice

between different accounting policies which can be divided between two categories which are the choice of accounting policies per se (non-discretionary accruals) and discretionary

accruals. The first category includes policies for revenue recognition or the type of inventory valuation method such as LIFO or FIFO and the second category includes accruals such as provisions and non-recurring writeoffs. Secondly, there are real actions that can effect the earnings, including tuning the expenses for R&D or advertising, disposing of capital assets, timing capital expenses and the use of overproduction to lower the costs of goods sold (Roychowdhury, 2006). Moreover, there is a “law” which the accruals follow and that is the accruals reserve, if accruals can not be sustained. If a manager would like to sustain high earnings and if the situation does not condone this, then even more earnings management is needed to sustain the earnings. Badertscher shows that this holds for firms that are overvalued by the capital markets (2011). He distinguishes three sorts of earnings management which overlap with eachother: within-GAAP accruals management (AM), real transactions management (RTM) and non-GAAP earnings management (NonGAAP). This is a good classification as it distinguishes between types of earnings management while accounting for the value implications of earnings management. Furthermore, earnings management does not have to be bad by definition, as will be described in the next subchapter.

2.2 Good versus bad earnings management

One could differentiate between good and bad earnings management pertaining to the firms’ value alone and to the intentions which the managers had, when they were managing the firm’s earnings.

A firm’s financial statements summarize the economic consequences of its business activities, therefore, the goal of a firm’s accounting is to capture its underlying business reality. Furthermore, firms have to do their accounting according to a particular set of rules. These rules are called GAAP, or generally accepted accounting principles. One exception is the use of IFRS, or international financial reporting standards which are used by certain firms

for accounting. These rules and the need to capture the underlying business reality sometimes clash with each other as the rules sometimes restrict a firm to show the underlying business reality. This is particulary true for hightech firms that are very dependent on R&D and so one could argue that the net income is not a parameter for the firms’ success.

Therefore a good side of earnings management is the circumnavigating of blocked communication, a concept highlighted by Demski & Sappington (1987). They argue that certain information is obtained by managers as part of their expertise, but it is too costly to communicate to the public, therefore making it blocked communication. This implies that earnings management can be a device to communicate certain inside information to the public. If a manager only announced certain information, it would not be credible as it would be too costly to verify the information for the public. But by using earnings management, the manager can make the inside information credible which is confirmed by another study of Demski & Sappington (1990).

On the other hand there is bad earnings management, also known as opportunistic earnings management. The study that Healy (1985) did, showed results that can be classified as opportunistic earnings management as the managers in the study tried to maximize their bonuses, which could be at the expense of the firm value in the long run.

This shows that earnings management can be called good or bad based on how it is used. However, there are value implications of earnings management for the firm value itself in the long run. There are different ways one could manage earnings, which were: within-GAAP accrual management, real transaction management and non-within-GAAP management.

First for within-GAAP accrual management can be good for firm value in the long run if it is not used for opportunistic earnings management, because not managing earnings leads to the lowering of firm value (Chen, Hemmer, & Zhang, 2007). According to Chen et al. (2007), this can be attributed to the fact that the market expects managers to manage earnings by using accrual earnings management and if the firm does not do this, then the firm value will decrease. Moreover, Subramanyam (1996) reports that the market, on average, attaches value to discretionary accruals. He shows evidence that it is used by the managers to improve the economic value of earnings. Furthermore, it is shown by studies by Xie (2001) and Sloan (1996) that investors overvaluate the discretionary accruals. But this overvaluation is

questioned by Tucker & Zarowin (2006) who show that this “overvaluation” can be attributed to the fact that the firms that manage earnings, manage them in a way that the earnings

contain more information about the future earnings. This suggests that the use of within-GAAP accrual management leads, if done for the right reasons, leads to a “real” value of the

firm in the long run. If earnings are not managed, this decreases the firm value and if they are managed to convey inside information, then the firm value in the long run will move to the true economic value. Moreover, the “iron law” of accruals states that accruals that are made and can not be sustained need to be taken back. This does not decrease or increase firm value in the long term. It is simply using accounting numbers to change earnings if earnings are managed.

Secondly, real transaction management does affect real cash flows directly, while within-GAAP accrual management does not. Real transaction management is found to be restricted under the presence of sophisticated investors. According to Roychowdhury (2006), this suggests that real transaction manipulation can be used to reach short-term earnings targets, but it is unlikely to contribute to long term firm value. It would rather destroy firm value in the long term. He also finds that managers manage earnings through real transactions, because they expect their private costs to be greater with managing accruals, meaning that they can not rely only on managing accruals. These private costs are expected to be higher, because it is expected that there is more auditor scrutiny pertaining to accrual management and at the end of the year, one can not manage earnings further with accrual management but one can with real transaction management (Graham, Harvey, & Raygopal, 2005).

Furthermore, non-GAAP earnings management is bad for the firm value on the long term. This is because non-GAAP earnings management is illegal, putting the firm open to potential lawsuits from outsiders and other causes of loss of firm value. The research of Palmrose & Scholz (2004) supports this notion. They find that firms with restatements have more chance to be subject to lawsuits, higher chance of bankruptcy, and more negative security price changes.

So according to the literature on earnings management, earnings management can be positive for the firm value in the long run if it is used to reveal inside information to the market. It is even recommended to manage earnings via within-GAAP accruals to reveal inside information to the market to help investors, because firm value would suffer if this is not done. However, literature shows that opportunistic within-GAAP accrual management, real transaction management and non-GAAP earnings management, on average, lower firm value in the long run. It is suggested that corporate governance can help restrain these agency problems (Core, Holthausen, & Larcker, 1999). That is why it is interesting to look at

different sorts of corporate governance. This paper will continue by describing the one- and two-tier boards. Moreover, this paper will analyse the literature which pertains to outside

directors on a board is on earnings management. Finally, this paper will try to draw

conclusions out of the literature analysed, show limitations of the studies used, and will try to make further suggestions for future research.

3. Outside directors and their characteristics

The accounting numbers that firms report are very important for external

stakeholders; it is the language used by the management of the firm to communicate with them. These external stakeholders rely on these numbers to differentiate between the poor and the good performers in the economy (Wahlen & Healy, 1999). Therefore, it is important that reporting standards are sound and one of the ways in which it is expected that this information becomes sounder, is to place outside directors on the board as it increases the independence which is expected to increase the quality of the financial information. Several organizations have published reports on the topic of outside directors and recommendations about characteristics that they must possess. In this part of the paper, it will be described what some of these recommended characteristics are, and there will be a description about boards in general. These topics will be analysed in the next chapter.

Outside directors are also called non-executive directors and are members on a specific board who are not an employee, officer or stakeholder in the company. Definitions differ per legal environment, because other environments believe that some characteristics are better whereas others are not needed. For example, some environments allow an outside director to hold some stock in the firm where he sits on the board, where others do not condone this as it would impair the independence of the outside director.

Boards include: the board of directors, audit committees and compensation committees. Fields & Keys (2003) also add that outside directors can potentionally select CEO’s and discharge them if performance is not satisfactory. These boards have in common that they have a monitoring role in the corporate governance of the organisation, and several reports stress this objective of these boards (Davidson, Goodwin-Stewart, & Kent, 2005).

Due to several accounting scandals and the failure of monitoring of managers, reports have introduced recommendations for outside directors, because there is a widely held concern about the board’s inability to ensure that management acts in the interests of

shareholders. This illustrates the agency problem in an organization. In an organization with share capital, there exists a separation between the owners of the firm and the ones who lead the firm on a day-to-day basis. There exists a chance that the management will act

self-centered at the costs of the shareholders. These costs are called the agency costs, and firms use corporate governance to diminish these costs as a system of checks and balances. To make the monitoring function of the board more effective, reports recommend placing outside directors on the boards, because there is significant evidence that more independent boards are less unfluenced by management (Weisbach, 1988). But there are differences between the recommendations of the proportion of outside directors to be placed on a board. Some reports recommend placing a majority of outside directors on a board, while others recommend placing only outside directors on a board.

Fields and Keys (2003) describe the rules of the New York Stock Exchange, which firms that are quoted on this exchange must follow. They require these firms to include the following rules on their boards: more than a half of the board members must be independent, and the compensation, audit and nominating committees must be entirely composed of outside directors. The NACD gives similar recommendations about the proportion of outside directors on the board, while also promoting a diversity of outside directors; in background and experience (NCAD Blue Ribbon Commission, 2005). It is also recommended to have outside directors that have financial knowledge, to effectively detect earnings management.

Moreover, this paper tries to approach this problem of corporate governance from the view of an one-tier board and a two-tier board, so the next two subchapters will give some information on these two boards and the perceived differences of the influences that outside directors would have on earnings management. It is given that board structure varies per nation, because they are subjected to their own legislation, cultural values, capital markets, investor protection, and accounting standards (Osma & Noguer, 2007). The literature on the topic of the proportion of outside directors on a board and the extent of earnings management gives mixed results and therefore will be analysed in chapter four.

3.1 Outside directors on a one-tier board

In one-tier systems, shareholders choose members on the board. These members then appoint the executives. The board can consist out of insiders, outsiders, or a mix of those. One-tier systems are often used in countries which have a shareholder-centric view, which means that the primary goal of the firm is to increase the wealth of the shareholder. Examples of these countries are the United States Of America and The United Kingdom, on which the majority of the studies pertaining to the proportion of outside directors on a board and their influence on earnings management has focused, and Japan. It is expected that a higher proportion of outside directors would give the board a higher independence. More

independence from management means that there should be less earnings management. However, there often is an information gap between the outside directors and the inside directors, because the inside directors are expected to have more inside information and expertise on the firm and the economic transactions that occur. Therefore, it is expected that, on average, there is more earnings management where outside directors need more inside information to detect it and less earnings management otherwise.

3.2 Outside directors on a two-tier board

In two-tier systems, shareholders choose supervision board members who are independent or outside directors. The supervisory board is responsible for placing board members on the board of directors and approving financial statements. The board of directors is also called the management board and is composed of the decisionmakers in the firm. Two-tier systems are often used in countries which have a stakeholder-centric view, which means that firms have an obligation towards increasing the wealth of all stakeholders, instead of only focusing on the shareholders’ wealth. Examples of these countries are Germany, China, Spain and the Scandinavian countries. Furthermore, there are also countries where a firm can choose whether it takes a one-tier board or a two-tier board, such as France. The information gap also exists here, but it is expected that this information gap is more severe, because it is often mandatory that supervision boards are consisted out of only outside directors. These supervisory boards rely on information that is prepared by management. Therefore,

management can control the flow of information to the supervisory board. Survey data even suggests that the quality of this information is often not satisfactory (Deloitte Touche Tohmatsu & Economist Intelligence Unit, 2004). This suggests that the information gap is bigger, in line with research by Van den Berghe & Levrau (2004). Therefore, it is expected that, on average, there is more earnings management when outside directors need more inside information to detect it and less earnings management otherwise. But because the information gap is even bigger than with an one-tier board, it is expected that two-tier boards detect even less earnings management if this inside information is needed to detect it.

4. Analysis

4.1 One-tier boards

Mentioned before was that there were three levels of earnings management: within-GAAP accrual management, real transaction management and outside-GAAP management.

Firstly, when the the public interest in outside directors and earnings management seemed to rise, it concluded in studies which researched earnings management on the level of outside-GAAP management. Beasley (1996) investigated this connection and found that the level proportion of outside directors was negatively correlated with thelikelihood of

accounting misstatements or fraud. Moreover, it also showed that a high proportion of outside directors on the board was more benificial for reducing the number of frauds than having an audit committee. He conducted the study by comparing a sample of firms that were accused of fraud with a sample of firms that were not. He found that the firms that did not commit fraudulent statements, had a higher proportion of outside directors on the board. Furthermore, (Dechow, Sloan, & Sweeney, 1996) also found that a higher proportion of outside directors leads to a lower percentage of financial statement fraud by firms that were subject to SEC accounting enforcement actions in the US. This seems to prove that a higher proportion of outside directors on a board leads to less outside-GAAP earnings management.

Secondly, there is real transaction management. There is less literature on the topic of outside directors and the extent of earnings management by using real transaction

management. Some evidence comes from Cohen, Dey, & Lys (2008). They study the extent of earnings management used in the period preceding the passing of the SOX legislation and in the period after the SOX legislation was passed. They find that the extent in which accrual management was used, rose significantly in the period preceding the passing of SOX and they find that in that same period the extent in which real transaction management was used decreased. After the passing of SOX, the extent in which accrual earnings management was used, decreased, while real transaction management rose significantly. Firstly, they use a modified Jones model for testing the level of abnormal accruals which was modified by Dechow et al. (1995). Secondly, they use the model for measuring real transaction management which is also used by Roychowdhury (2006). This model considers the

abnormal level of cash flows from operations, discretionary expenses and production costs to measure the level of real transaction management. Later studies have verified the validity of the proxies that are used here to measure real transaction management (Cohen et al., 2008).

The authors claim that the reason why more firms are engaging in real transaction management can be explained by the fact that real transaction management is harder to detect, while accrual management is easier to detect, despite it being more costly for the firm in the long run. They further add that this is consistent with an earlier survey by Graham et al. (2005) who find that managers have more incentive to use real transaction management,

managers received an increasing part of their compensation in the form of options in the period before SOX, and after SOX passed, this part of compensation declined. Furthermore, they find that unexercised options are positively correlated with discretionary accruals that increase earnings, and that this connection does not hold in the period after SOX. This suggests that managers preceding the passing of SOX, managed their earnings upwards to receive more compensation due to their options. This has declined since the passing of SOX. Consistent with the findings on the subject of accrual management and real transaction management, Chen, Cheng & Wang (2011) mention similar results, but they relate it to the proportion of outside directors on the board after the passing of legislation and they find that outside directors find it harder to detect these real transactions that manage earnings. They suggest that this is possibly due to the fact that it is harder for outside directors to monitor real transactions management, because managers have inside information and the expertise with respect to economic transactions. So these economic transactions are more difficult for outside directors to understand, while acrual earnings management is not. So the rise of real transaction management can potentionally be contributed to the fact that there is a bigger proportion of outside directors on the board after the passing of the legislation.

Finally, within-GAAP accrual management and the association with corporate governance is a relatively new area of research (Davidson et al., 2005). There has been a lot of research on the topic of the effect of outside directors on accrual earnings management, but this has significantly been focused on the type of board called the one-tier board. The two-tier board is used in countries such as Spain, Germany, and China.

Peasnell, Pope, & Young (2005) investigated the influence of outside directors and they found that firms with a higher proportion of outside directors have a lower chance that managers use income-increasing abnormal accruals to report a higher profit as to avoid having a loss or a reduction in earnings. Moreover, they found that the chance that abnormal accruals are used to just receive a positive profit or to not reduce the earnings compared to the previous year does decline significantly when a high proportion of outside directors are on the board. They also test whether the accruals that are made, are for signaling purposes, or not. They find that they are not used for signaling. They conclude that boards with a

significant proportion of outside directors does contribute to the integrity of financial

statements. These conclusions are in line with the saying that outside directors make effective monitors and try to maintain the value of their reputational capital (Fama & Jensen, 1983). However, a study that investigated the link between the proportion of outside directors on the board and abnormal accrual earnings management in Canada found that outside directors on a

whole did not reduce earnings management, but outside directors from financial

intermediaries did. This shows that financial knowledge is an important characteristic for outside directors. However, the authors did make a remark that showed a limitation for the interpretation of the results and that is the fact that the labor market for outside directors is not as developed (Park & Shin, 2004). This means that outside directors as a whole could be a contributing factor the reduced abnormal accrual earnings management if the labor market has developed. Furthermore, a study by Klein (2002), who also shows that there is a negative relationship between abnormal accruals and the proportion of outside directors on a board, shows that the board is even more effective if it is independent from the CEO who can be the head of the board on a one-tier board. Klein also controlled for the endogeneity problem that is encountered in this research. This is the issue of whether board composition leads to less earnings management or whether a certain kind of earnings management leads to a certain board composition. Board composition can be exogenous or endogenous according to Adams et al. (2010).

4.2 Two-tier boards

There has been less research on two-tier boards and the proportion of outside directors and their influence on earnings management. Research has mainly focused on two countries and those two are The United States of America and The United Kingdom (Osma & Noguer, 2007). The monitoring and the decisionmaking bodies are separated here. Firsly, Osma & Noguer (2007) investigated the link between the proportion of outside directors on a board and the extent in which abnormal accrual earnings management existed. They concluded, based on their data, that a higher proportion of outside directors on a board could only lead to reduced earnings management if there was a nomination committee that would solely consist of inside directors. If this was not present, then more independent directors would lead to an increase in abnormal earnings management. According to the authors, this could be

contributed to the fact that the Spanish ownership structures, legal tradition, quality of enforcement, and investor protection are different from the UK and US models. This study also controlled for the endogeneity problem. Secondly, Firth, Fung, & Rui (2007) who do their investigation on firms in China, find that the proportion of outside directors on a board is negatively correlated with the extent into which abnormal accrual earnings are managed. China also uses a two-tier board and has some similar characteristics as Spain; China also has a weak legal system and a low investor protection. But Omar & Noguer (2007) suggest that this also can be contributed to the fact that there are large Spanish blockholders of shares, so

that these blockholders monitor these managers similarly to traditional owners. All, in all there is mixed evidence for the fact that outside directors create a board which does not manage its earnings extensively in a two-tier board governance area.

5. Conclusion

In this paper the following research question has been posed: what is the influence of the proportion of outside directors on a board on earnings management? Several corporate frauds and accounting scandals have led to the fact that not only regulators and boards have been showing more interest in the independence of decisionmakers in firms, but also the general public and society as a whole. And since the capital market relies on information that the management of firms prepare, it is important for them that this information shows the true economic consequences of the business activities of a firm. One of the corporate governance tools available is the introduction of independent directors, or outside directors on a board. Several reports have been brought out with recommendations on the characteristics of these outside directors to make sure that these directors are truly independent. With these

recommendations having been brought into practice by several organizations, researchers could now research if these changes could really contribute to the reduction of earnings management. Therefore, this paper tried to analyse existing literature to investigate what the influence of the proportion of outside directors on a board is on the extent in which earnings are managed, while separating the one-tier and the two-tier board. This paper focused on three categories of earnings management, namely non-GAAP earnings management, real transaction management, and within-GAAP earnings management.

Firstly, on a one-tier board it was shown that, on average, the extent in which non-GAAP earnings management persisted, was influenced negatively by the proportion of outside directors on a board. The firms that commited non-GAAP earnings management had a lower proportion of outside directors on their board, while the firms that did not commit non-GAAP earnings management had a higher proportion of outside directors on their boards. Furthermore, it was shown that ,on average, the extent in which real transaction management persisted, was positively influenced by the proportion of outside directors on a board.

According to the literature, this can be contributed to the fact that auditors show more scrutiny to accrual earnings management persists, so firms are more motivated to use real transaction management to manage their earnings. Furthermore, real transaction management is harder to detect, because inside directors have inside knowledge about these economic

transactions and the expertise to notice these economic transactions. Moreover, it was shown that, on average, within-GAAP earnings management was influenced negatively by the proportion of outside directors on a board. Outside directors reduce this earnings management by acting as professional referees among inside directors to maximize the shareholder value.

Secondly, on a two tier board, there were mixed results due to a low amount of research on these boards. This is contributed to the fact that the majority of research has focused on these issues in the United States of America and the United Kingdom. In this paper, however, a study that focused on Spain and China were analysed, which focused on two-tier boards. The study in Spain found that outside directors did not reduce abnormal accrual earnings management, but that they would increase it. The proportion of inside directors on a board influenced earnings management negatively. This could be contributed to the fact that the Spanish governance structures are drastically different from the US and UK ones. Moreover, the structure of shareholders of Spanish firms would be characterised by family blockholders of shares that would monitor managers extensively just like traditional owners would. However, the study from China concluded that the proportion of outside directors on a board contributed to a reduction in abnormal accrual earnings management, while the legal environment in China suffered from the same problems as in Spain. Non-GAAP earnings management and real transaction earnings management was not analysed in this paper, because there was no literature on this that related the proportion of outside directors and the extent in which earnings were managed on a two-tier board.

Therefore, on basis of the literature that was analysed and the two categories of boards that were set, the research question in this paper can be answered. On a one-tier board it is shown that, on average, the proportion of outside directors on a board negatively influences the extent in which Non-GAAP and within-GAAP accrual earnings management persists, while it positively influences the extent in which real transaction earnings management persists. On a two-tier board, it is shown that there are mixed results in which extent the proportion of outside directors on a board influences the extent in which earnings are

managed. It seems that outside directors contribute to the integrity of the financial statements on a one-tier board, however more research has to be done on this topic with a two-tier board to draw conclusions on this particular part of the subject. The contribution of this paper is that it summerizes and analyses preceding literature on the topic of outside directors’ influence on earnings management. This is useful for academic purposes, because prior literature has

comparison is useful. Secondly, there have not been a lot of papers that have done this. Finally, the results of this study could potentionally be of importance to legislators, because this study clarifies the role of the board as determinant of earnings management.

However, this paper is subject to several limitations. Firsty, this paper does not include all revelant literature on this topic, but a selection of the most important papers, because there were time constraints. Secondly, several studies were subject to the

endogeneity problem described earlier in this paper, correlation does not imply that there is causuality. Therefore, the conclusions must be interpreted carefully. Similarly is the

limitation with respect to the overall generalisability of the conclusions from this paper. The literature was primarly the outcome of studies done in The United States of America and the United Kingdom. That is why the conclusions from these studies can not be applied to every country, because of the other environments as witnessed in the study from Osma & Noguer (2007).

In this paper, it becomes clear that the overall literature was research that focused on two countries with different legal systems, labor markets for outside directors, and quality of enforcement. Therefore, we witnessed studies that had other outcomes than these studies, on average, had. That is why it could be interesting to do more research on these topics.

Moreover, because literature primarly focused on those two countries with a one-tier board and because there was not enough literature on two-tier boards and the proportion of outside directors on a board and their influence on earnings management, it could be interesting to do more research on this.

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