The influence of Auditing Standard No. 16 by the PCAOB on
the quality of financial reporting and both the composition
and activity of the audit committee
Master thesis
Student name: Niels Kok Student number: 10853928
Supervisor: Georgios Georgakopoulos
Date: 14-06-2016
Word count: 17.301
MSc Accountancy & Control, specialization: Accountancy Faculty of Economics and Business, University of Amsterdam
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Statement of Originality
This document is written by student Niels Kok who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
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Abstract
The PCAOB has been reaching out to audit committees in order to gather input for its activities and help the committees in the performance of their duties. Among others, this has resulted in the adoption of Auditing Standard No. 16, which is effective since December 2012 (PCAOB, 2012). This standard requires the external auditor to communicate with the audit committee of the firm, regarding certain matters related to the conduct of an audit and certain audit information, which are relevant for the audit committee. Based on analysis using 1,728 firm-year observations from S&P 500 firms from 2010 to 2015 and comparing the pre-period (i.e. 2010 to 2012) with the post-period (i.e. 2013 to 2015), this study examines whether the Auditing Standard No. 16 by the PCAOB has increased the quality of financial reporting and has changed the composition and activity of the audit committee.
This study finds that only audit committee expertise, and not audit committee activity, significantly increased following Auditing Standard No. 16. The overall earnings management did not decrease significantly after the adoption of the standard. Also, the results indicate that the presence of more audit committee members with financial expertise or more audit committee meetings does not lead to a negative effect on discretionary accruals and thus does not lead to a positive effect on financial reporting quality. Furthermore, the relation between both audit committee expertise and audit committee activity and earnings management did not significantly change following Auditing Standard No. 16. The previous point suggests that the effectiveness of the audit committee, in overseeing and monitoring the financial reporting and accounting processes, did not increase as a result of the mandated communication between the audit committee and the external auditor by Auditing Standard No. 16. These results are consistent with the conclusions of Romano (2005), Zhang (2007) and Ghosh et al. (2010) who cast doubt on the effectiveness of new regulation with respect to the effectiveness of the audit committee in improving the financial reporting quality. The results suggest that, from the perspective of the audit committee, regulating the communication between the audit committee and the external auditor is not effective in setting up a global model to improve financial reporting. However, given the fact that this study is subject to several limitations, this study cannot provide insight on the overall effectiveness of Auditing Standard No. 16 by the PCAOB.
Keywords: Audit Committee; Audit Committee Expertise; Audit Committee Meetings; Financial
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Table of Contents
1. Introduction ... 5
2. Literature review and hypotheses ... 9
2.1. Audit committee ... 9
2.2. Audit committee characteristics ... 10
2.3. Financial reporting ... 13
2.4. Auditing Standard No. 16 ... 15
2.5. Hypotheses development ... 17
3. Research methodology ... 22
3.1. Data collection and sample selection ... 22
3.2. Dependent variable ... 23
3.3. Independent and control variables ... 26
3.4. Empirical design ... 30 4. Results ... 31 4.1. Descriptive statistics ... 31 4.2. Correlation matrix ... 34 4.3. Regression analysis ... 36 5. Conclusion ... 40 References ... 43 Appendixes ... 49
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1. Introduction
The role of external auditors has been increasingly criticized because of the growing number of financial reporting scandals. Examples of such scandals are unethical behaviour by top management (Low et al., 2006) like the off balance debts from Enron in 2001 or the inflated assets from WorldCom in 2002. The government and the public opinion raised questions to the contribution of the auditors and the role and scope of auditing, both in law and in auditing standards (Humphrey et al., 2011). In response to the previously mentioned, the U.S. Securities and Exchange Commission (hereafter the SEC) introduced in 2002 the Sarbanes-Oxley Act (hereafter the SOX act). This act was enacted to improve the accuracy and reliability of corporate disclosures, to strengthen the corporate governance systems and to protect the investors from fraudulent accounting practices (SOX, 2002). As part of the mission to achieve good corporate governance, the SOX act focused on the audit committee in order to find the best way to oversee and monitor the financial reporting and accounting processes. The SOX act enhances the power and responsibilities of audit committees and introduced the Public Company Accounting Oversight Board (hereafter PCAOB) (Malik, 2014).
Merchant and Van der Stede (2007) state that the audit committees play a vital role in the capital market. The objective of the audit committee is to provide independent oversight over firm’s financial reporting process, internal controls, and independent auditors. The ultimate goal of the audit committee is to ensure high financial reporting quality (Malik, 2014). Oversight bodies have the objective to control the quality and trustworthiness of the audit committee by focusing on the characteristics, which according to Malik (2014) are the most significant features to achieve this goal.
As part of the mission, to protect the interest of investors and the public interest, the PCAOB has been reaching out to the audit committees in order to gather input for its activities and help the committees in performing their duties. This has been mostly done by adopting new, or improving existing, auditing standards. Among others, this has resulted in the adoption of Auditing Standard No. 16, which is effective since December 2012 (PCAOB, 2012). Auditing Standard No. 16 requires the external auditor to communicate with the audit committee of the firm, regarding certain matters related to the conduct of an audit and certain audit information, which are relevant for the audit committee. This includes communication with regard to the overall audit strategy including the timing of the audit and significant risks (PCAOB, 2012).
Previous research indicates that the interaction between the external auditor and the audit committee is crucial to achieve high financial reporting quality (Cohen et al., 2004). Auditing
6 Standard No. 16 can influence this interaction and thereby the effectiveness of the audit committee in overseeing and monitoring the financial reporting and accounting processes. The mandated communication can also influence the composition and activities of the audit committee. The results of Ghosh et al. (2010), who investigated the audit committee composition and activity and earnings management before and after the SOX act, indicate that the composition and activity of the audit committee were undergoing significant structural shifts because of the regulatory changes. This study investigates the impact of the mandated communication from Auditing Standard No. 16. More specifically, it will examine whether results following the research by Cohen et al. (2014) and Ghosh et al. (2010) apply to the adoption of Auditing Standard No. 16. Consequently, the following research question has been formulated:
To what extent does the financial reporting quality and both the composition and activity of the audit committee change after the adoption of Auditing Standard No. 16 by the PCAOB?
This study investigates the impact of the mandated communication on the effectiveness of the audit committee and if this mandated communication has led to a change in the composition and activity of the audit committee. To the best of my knowledge, the influences of the Auditing Standard No. 16 by the PCAOB on financial reporting quality and the composition and activity of the audit committee is never examined before.
This study makes several contributions to existing literature. First, this study contributes to the call for further research from different researchers. Malik (2014) states that further research can examine how requirements increase the activities of the audit committees in terms of audit committee interaction with required parties. Auditing Standard No. 16 requires interaction between the audit committee and the external auditor. Malik (2014) also states that further research can examine how other regulations interact with the SOX act and influence audit committee effectiveness. Another call for further research is from Ghosh et al. (2010), who state that results from a more recent sample might provide additional insights in the effect of regulation on the effectiveness of the audit committee.
Second, this study contributes to the literature that investigates the effects of the changes in regulation on the characteristics of the audit committee. This study investigates whether the composition and activity of the audit committee has changed following Auditing Standard No. 16. By comparing the pre- and post-Auditing Standard No. 16 periods, this study provides insight on the effect of regulation on audit committee characteristics. Previous studies have investigated the impact of different regulation changes. Ghosh et al. (2010) examined the effect of regulation on
7 audit committee characteristics. They found, by comparing the pre- and post-SOX periods, that the audit committee characteristics have undergone structural shifts because of regulatory changes. Munro and Buckby (2008) found that some audit committee characteristics have changed after the adoption of the Australian corporate governance principles in 2003.
Third, this study contributes to the literature that investigates the direct relation between regulations and financial reporting quality. This study investigates whether accrual-based earnings management declined following Auditing Standard No. 16. Considering that the recent regulatory changes are initiatives to strengthen the board oversight role, this study examines the relation between regulation changes and earnings management, as proxy for financial reporting quality. By comparing two different regulatory periods (pre- and post-Auditing Standard No. 16), this study can assess whether, as intended, regulation in the US has enhanced the quality of financial reporting.
Fourth, this study contributes to the literature that examines the relationship between the audit committee and financial reporting quality. This study investigates whether audit committee characteristics are associated with earnings management and whether there is a shift in this relationship for the years following Auditing Standard No. 16. Drawing on existing research (i.e. Klein, 2002; Xie et al., 2003; Anderson et al., 2004; Ghosh et al., 2010) this study analyses the composition and activity of the audit committee and how this affects the financial reporting quality. More specifically, this study focuses on the audit committee members with financial expertise and audit committee meetings. While several studies examine the influence of corporate governance on financial reporting in the US, these studies primarily used data before 2005, when the regulatory and work environment was noticeably different. This study will contribute to existing research by analysing a more recent period (i.e. 2010 to 2015). Finally, the results of this study can serve as input for the discussion on the benefits and threats of the harmonization of international corporate governance and to the benefits of regulatory governance-related initiatives (e.g. Greene and Boury, 2003; Lannoo and Khachaturyan, 2004; Gosh et al., 2010).
Also, this study has practical relevance. The results of this study can be used to improve the effectiveness of the audit committee. Also, the results of this research can also have important implications for oversight bodies such as the SEC and PCAOB. If the results indicate that the standard is not effective, oversight bodies should consider other means to improve the effectiveness of the audit committees and financial reporting quality, and thereby to protect the investors from fraudulent accounting practices.
The results of this study are based on a comprehensive sample of 1,728 firm-year observations from Standard & Poor’s 500 (hereafter S&P 500) firms between 2010 and 2015. This
8 research focuses on S&P 500 firms since listed firms in the United States are required to follow the mandated regulations by the PCAOB. This study analysed the pre- and post-Auditing Standard No. 16 periods and used the Modified Jones Model from Dechow et al. (1995) to measure the discretionary accruals as proxy for financial reporting quality. This study finds evidence that some audit committee characteristics have undergone significant structural shifts due to the change in regulation but found no evidence that the financial reporting quality increased significantly because of the adoption of Auditing Standard No. 16. Also, it finds that the presence of more audit committee members with financial expertise or more audit committee meetings does not lead to a decrease of earnings management. The relation between both audit committee expertise and audit committee activity and earnings management did not significantly change following Auditing Standard No. 16.
The remainder of this study is structured as follows: section two will describe the literature review related to the audit committee and financial reporting, followed by the hypotheses development. Section three will discuss the research design and sample selection process. Section four will provide the main results and finally section five will conclude this research.
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2. Literature review and hypotheses
2.1. Audit committee
An audit committee is an operating committee within the corporate governance system (Zaman et al., 2011). Merchant and van der Stede (2007) define corporate governance as “the sets of
mechanisms and processes that help ensure that companies are directed and managed to create value for their owners while fulfilling the responsibilities of other stakeholders” (Merchant and
van der Stede, 2007, p. 553). The main activity of corporate governance is to monitor the management; the audit committee helps with this activity. In section 2 of the SOX act (2002) is the audit committee defined as:
“A committee (or equivalent body) established by and amongst the board of directors of an issuer for the purpose of overseeing the accounting and financial reporting processes of the issuer and audits of the financial statements of the issuer; if no such committee exist with respect to an issuer, the entire board of directors of the issuer.” (SOX, 2002, 116 STAT. 747)
In the beginning, the committee was suggested as channel of communication between the external auditor and management, and to reduce the liability of the board (Pincus et al., 1989). Nowadays, the audit committee has also an oversight role and can be seen as an important element in the corporate governance process. The main roles of the audit committee are overseeing and monitoring the financial reporting process and provide advice in the selection and termination of the external auditor (Felo et al., 2003). An effective audit committee should increase the independency of the external auditor, which minimalizes the possibility that factors will influence the judgments and decisions of the external auditor. The audit committee plays an important role to improve the quality of the financial statements (Felo et al., 2003). The PCAOB (2012) confirms this role; the audit committee plays according to the PCAOB:
“An important role in protecting the interest of investors by assisting the board of directors in fulfilling its responsibility to a company’s shareholders and others to oversee the integrity of a company’s accounting and financial reporting process and audits.” (PCAOB, 2012, p. 2)
10 The New York Stock Exchange (hereafter the NYSE) endorsed the first concept of the audit committee in 1939 (Spangler and Braiotta, 1990). The audit committee became, because of the important role during the 1970s due to the great demands for corporate governance and corporate accountability, a required committee for all listed firms in the United States. Over the next years, new recommendations and regulations were suggested to improve the effectiveness of the audit committee, resulting in the Report and Recommendations of the Blue Ribbon Committee in 1999 (hereafter BRC) (BRC, 1999; Beasley et al., 2009). The main goal of the BRC was to develop guidelines to improve the effectiveness of the audit committee and thereby improve the financial reporting quality (BRC, 1999).
Besides the fact that the BRC (1999) recommends that listed firms with more than 200 million dollars of market capitalization should have an audit committee, they have some important recommendations about audit committee characteristics that should increase the effectiveness of the audit committee. These recommendations consist of four important characteristics; (1) the members of the audit committee must be independent; they must have no relation with the corporation; (2) the audit committee must consist of at least three members, who all should be financially literate, or become one within a reasonable period of time; (3) at least one of the audit committee members should have an accounting or financial management expertise; and (4) the BRC recommends that the audit committee must have at least four meetings every year, otherwise it is reasonable that they are not capable to fulfil its duties to oversee and monitor the financial reporting and account processes (BRC, 1999).
A few years later in 2002, as response to financial reporting scandals, the SEC passed the SOX act, to address the concerns of investors regarding the integrity of firm’s financial reports. Different sections of this act focus on the audit committee, the SOX act has included and required a number of BRC’s recommendations in order to improve the operational efficiency, effectiveness and independence of the audit committee (SOX, 2002; Zhang et al., 2007).
2.2. Audit committee characteristics
Different oversight bodies like the BRC and the SEC made recommendations and implemented requirements about the audit committee of firms with the attention to increase the quality and effectiveness of the audit committee. The main requirements and recommendations relate to the composition and activity of the audit committee (BRC, 1999; SOX, 2002). According to recommendations of the BRC (1999) the most important characteristics of the audit committee are the independence and financial expertise of the audit committee members and the size and the activities of the audit committee (BRC, 1999).
11 A recommendation of the BRC from 1999 that the SEC required in 2002 with the SOX act is that every audit committee from listed firms in the United States must consist of independent audit committee members. This means that no members should have a relationship with the management of the firms that may interfere their independence (BRC, 1999; SOX, 2002). Independent audit committee members are expected to be more interested in reducing the likelihood of fraud and earnings management to demand a high quality of financial reporting (Peasnell et al., 2005; Hubaid and Cooke, 2005). Recent research has examined the relation between the independence of audit committee members and the quality of financial reporting. For example, Bedard et al. (2004) showed a significant reduction in the likelihood of aggressive earnings management when all the audit committee members are independent. Consistent with this, Klein (2002) found a positive relation between independent members and the resistance of pressure of the management; independent members are better able to maintain their objectivity. Xie et al. (2003) agree with this, they found that the percentage of outside audit committee members is negative related with accrual-based earnings management. Furthermore Abbot et al. (2004) and Carcello et al. (2011a) found, after measuring the audit quality with the occurrence of restatements, evidence that there is a negative relationship between the independence of the audit committee and the occurrence of restatements. Collectively, these studies indicate that there is a positive relation between the independence of audit committee members and the quality of financial reporting. But there is also a downside risk about independent members. Completely independence could lead to fewer company and industry specific knowledge, which can negatively impact the level of monitoring (Aldamen et al., 2012)
Another recommendation of the BRC (1999) that became a requirement in 2002 with the SOX act is that at least one of the audit committee members must have financial experience (SOX, 2002). SOX defined in section 407, a financial expert as a person who has the following attributes:
“(1) An understanding of generally accepted accounting principles and financial statements; (2) experience in (A) the preparation or auditing of financial statements of generally comparable issuers; and (B) the application of such principles in connection with the accounting for estimates, accruals, and reserves; (3) experience with internal accounting controls; and (4) an understanding of audit committee functions.” (SOX, 2002, 116 STAT. 790)
However, as reaction on the negative commenters that thought that the proposed definition was too restrictive, the SEC changed the financial expert definition. The final rules issued by the
12 SEC define a financial expert as a person that has experience with the preparing, auditing, analysing or evaluating financial statements. It is also not required to have a financial expert in the audit committee, but the consequence is that firms without an audit committee financial expert must disclose this fact and explain why it has no such expert (SEC, 2003).
Different researches support the requirement of the SOX act to have at least one financial expert in the audit committee. For instance, Felo et al. (2003) and Bedard et al. (2004) found a significant negative relation between audit committees with financial experts and earnings management. Both conclude that the presence of financial experts in the audit committee reduces the likelihood of aggressive earnings management and thereby increases the quality of financial reporting. Consistent with this, Abbot et al. (2004) found a significant negative association between restatements and an audit committee that includes at least one financial expert. Furthermore, Krishnan and Visvanathan (2008) and Beasley et al. (2009) found that financial expertise is positive correlated with conservatism, which decreases the probability of aggressive earnings management and thereby increases the quality of financial reporting. Finally, Xie et al. (2003) found that the background of the audit committee members is important to influence aggressive earnings management. Their findings showed that members with an investment banking background are negative associated with aggressive earnings management, but members with a financial banking background do not influence it. Collectively, these studies indicate that financial expertise in the audit committee increases the quality of financial reporting because of better overseeing and monitoring of the financial reporting and accounting processes.
While the SOX act has no requirements of the size of the audit committee (SOX, 2002), the BRC recommends that an audit committee should have at least three members (BRC, 1999). The corporate governance of an entity must make a trade-off between the benefits and the negative effects of more members in the audit committee. Felo et al. (2003) found a positive relation between the number of members in the audit committee and the financial reporting quality. With more members, there are more resources available, which increase the likelihood to uncover and resolve potential problems. Zaman et al. (2012) agree with this, they argue that larger audit committees are more likely to discover potential problems because they have more access to recourses, which helps the committee to monitor and oversee the financial reporting and accounting processes. Bedard et al. (2004) argues that the objective is to have an audit committee that is large enough to ensure effective monitoring, but not so large to become unwieldy. They didn’t find a positive relation between the size of an audit committee and earnings management. Collectively, the overall findings of these studies indicate that there is a positive relation between the size of an audit committee and financial reporting quality.
13 Finally, the last important recommendation of the BRC about audit committee characteristics, which is not mentioned in the SOX act, is the activities of the audit committee. The BRC recommends that the audit committee should have at least four meetings every year, otherwise is the committee not capable to fulfil its duties to oversee and monitor the financial reporting process (BRC, 1999). Several studies agree with this. The results of the research of Abbott et al. (2004) show that an active audit committee is positive associated with lower fraud incidences. Raghunandan et al. (2003) find that regular meetings between the audit committee and the external auditor leads to more relevant information and knowledge about internal accounting and auditing issues. Vafeas and Larmou (2010) find that there is a positive relation between the frequency of audit committee meetings and earnings quality. Collectively, these studies indicate that an active audit committee is positive related to the quality of financial reporting.
The remainder of this study will limit itself to audit committee members with financial expertise and audit committee activity
2.3. Financial reporting
Financial reporting provides information about the features of the financial performance of a firm (Dechow et al., 2010). This information can be relevant for specific decisions, made by a specific decision maker (Dechow et al., 2010). Healy and Wahlen (1999) agree with this, financial reporting can provide a “relatively low-cost and credible means for management to portray a
firm’s financial performance and economic position and distinguish themselves for poorer performing firms” (Healy and Wahlen, 1999, p. 336). Financial reporting adds only value
assuming that the credibility of financial reporting is safeguarded (Healy and Wahlen, 1999). Firms with high quality financial reporting are more transparent to their shareholders, which can lead to better decisions, made by these shareholders (Dechow et al., 2010).
To better understand the importance of high quality financial reporting, it is necessary to explain the agency theory. This theory describes the structure of economic exchange between the principal (investor), who delegates the decisions and compensates the agent, and the agent (manager) who performs a task (Jensen and Meckling, 1976). The structure of economic exchange between the principal and agent can create problems because of information asymmetry (Jensen and Meckling, 1976). The manager can have information advantage over the investor, which can create adverse selection and moral hazard; the managers can have more knowledge of the value of the firm than investors (adverse selection) and managers cannot act in the best interest of their investors because of different interests (moral hazard) (Jensen and Meckling, 1976). Financial reporting can help reducing information asymmetry (Scott, 2012). Investors need financial
14 reporting information from high quality to estimate the true value of the firm and to monitor and incentive the managers to act in accordance with the investors’ interest (Jensen and Meckling, 1976). The audit committee is an important mechanism in reducing information asymmetry; they are responsible for overseeing and monitoring the financial reporting process and for the oversight of the external auditor, as reinforced by the SOX act (SOX, 2002). An important objective of the audit committee is to ensure high financial reporting quality (Scott, 2012).
Although oversight bodies like the SEC stress the importance of high quality financial reporting, the key problem found in prior literature is how to operationalize and measure this quality. Different users have dissimilar quality preferences; this makes it difficult to measure quality directly (Botosan, 2004). Consequently, many researchers (e.g. Reichelt and Wang, 2010; Dechow et al., 2010; Carcello et al., 2011b; Cohen et al., 2004) measure the quality of financial reporting indirectly with different proxies that are believed to influence the quality of financial reporting, such as financial restatements, fraud or earnings management. The presence of these proxies has been used as evidence of audit committee failures to monitor and oversee the financial reporting and accounting process (Carcello et al., 2011b; Cohen et al., 2004).
While financial restatements and frauds typically involve violations of Generally Accepted Accounting Principles (hereafter GAAP), earnings management involve managing accruals within the boundaries of GAAP (Romanus et al., 2008; Carcello et al., 2011b). Under the current GAAP regulations, managers have a considerable amount of discretion regarding the computation of earnings. Accruals is an accounting method that measures the performance and position of a firm by recognizing economic events regardless of when cash transactions occur. Accruals allow opportunistically managers to manage earnings, also known as earnings management, for various gains (Carcello et al., 2011b). Prior studies state that earnings management is an important proxy to measure the quality of financial reporting; lower earnings management leads to higher financial reporting quality (Nichols & Wahlen, 2004; Klein, 2002; Becker et al., 1998; Barth et al., 2008).
Earnings management, is defined by Healy and Wahlen (1999) as:
“Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.” (Healy and Wahlen, 1999, p. 368)
There are a lot of reasons to manage earnings. A well-known theory about this topic is the positive accounting theory of Watt and Zimmerman (1986). The positive accounting theory tries
15 to explain the reasons why managers engage with earnings management with three hypotheses. The first one is the bonus plan hypothesis; this hypothesis states that managers want to maximize their bonuses (Scott, 2012). The second hypothesis is the debt covenant hypothesis; managers try to avoid potential debt covenants agreement violations, because this may cause potential penalties (Scott, 2012). The third and final hypothesis is the political cost hypothesis; companies may prefer to lower earnings to avoid reputation damage (Scott, 2012). Roychowdhury (2006) agrees with the positive accounting theory of Watt and Zimmerman (1986); a common underlying market motivation to manage earnings is to meet or beat the expectation of financial markets. Different accrual models, like the Modified Jones model, can be used to measure the extent of earnings management under the current GAAP regulations (Healy & Wahlen, 1999; Dechow et al., 1995). Earnings management can increase information asymmetry and therefore they can undermine the quality of financial reporting (Krishnan et al., 2011).
2.4. Auditing Standard No. 16
Beside the fact that the SOX act from 2002 established regulations and recommendations, the act also established the PCAOB to oversee the audits of public companies in order to protect investors and the public interest (SOX, 2002). To protect the interest of investors and the public interest, the PCAOB has been reaching out to the audit committees in order to gather input for its activities and help the committees in the performance of their duties. This has been mostly done with the adoption of new, or improving existing, auditing standards. Among others, this has resulted in the adoption of Auditing Standard No. 16, which is effective since December 2012 (PCAOB, 2012).
Auditing Standard No. 16 requires the external auditor to communicate with the companies audit committee; the standard requires the external auditor to establish an understanding of the terms of the audit engagement with the audit committee. Additionally, the standard requires the external auditor to record the term of the engagement in an engagement letter, which must be executed by the appropriate party on behalf of the company and determine that the audit committee has acknowledged and agrees to the terms (PCAOB, 2012).
The adoption of the standard is in the public interest; the standard establishes requirements that enhance the relevance, timeliness and quality of the communication between the external auditor and the audit committee (PCAOB, 2012). This should facilitate the audit committee for the purpose of monitoring and overseeing the financial reporting and accounting processes (PCAOB, 2012). The standard is intended to improve the audit by stimulating structural dialogue between the external auditor and the audit committee about significant audit and financial statement
16 matters. The auditor and the audit committee will benefit both from the two-way communication, the audit committee in conducting its oversight responsibilities and the external auditor in conducting an effective audit (PCAOB, 2012). Auditing Standard No. 16 requires the external auditor to communicate, among other matters, the following items to the audit committee:
“An overview of the overall audit strategy, including timing of the audit, significant risks the auditor identified, and significant changes to the planned audit strategy or identified risks;
Information about the nature and extent of specialized skill or knowledge needed in the audit, the extent of the planned use of internal auditors, company personnel or other third parties, and other independent public accounting firms, or other persons not employed by the auditor that are involved in the audit;
The basis for the auditor’s determination that he or she can serve as principal auditor, if significant parts of the audit will be performed by other auditors;
Situations in which the auditor identified a concern regarding management’s anticipated application of accounting pronouncements that have been issued but are not yet effective and might have a significant effect on future financial reporting;
Difficult or contentious matters for which the auditor consulted outside the engagement team;
The auditor’s evaluation of going concern;
Department from the auditor’s standard report; and
Other matters arising from the audit that are significant to the oversight of the company’s financial reporting process, including complaints or concern regarding accounting or auditing matters that have come to the auditor’s attention during the audit.” (PCAOB, 2012, p. 11)
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2.5. Hypotheses development
The adoption of Auditing Standard No. 16 of the PCAOB requires more communication between the external auditor and the audit committee. The external auditor and the audit committee will benefit both from the two-way communication, the audit committee in conducting its oversight responsibilities and the external auditor in conducting an effective audit (PCAOB, 2012). It is important that the audit committee members understand the language of the external auditor. Sharma and Kuang (2014) argue that audit committee members with financial expertise are better able in monitoring and overseeing the financial reporting and accounting process; audit committee members with financial expertise are better able to understand the internal and external auditors, which makes it easier to prevent and detect material misstatements. Zhang et al. (2007) agree with this, they argue that the oversight role of the audit committee in the financial reporting process becomes more effective with financial audit committee experts. Ghosh et al. (2010) examined the effect of regulation on audit committee characteristics. They found, by comparing the pre-SOX and post-SOX periods, that the audit committee characteristics were undergoing structural shifts because of these regulatory changes. Munro and Buckby (2008) agree with this, they have conducted research in Australia about the relationship between the adoption of the Australian corporate governance principles in 2003, which has similar principles as the SOX act, and audit committee characteristics. The results of Munro and Buckby (2008) indicate that the number of financial experts in the audit committee have increased subsequently due the adoption of the new regulation. The adoption of Auditing Standards No. 16, which requires more communication between the external auditor and the audit committee, can also have influence on audit committee expertise. More communication between the external auditor and the audit committee will lead to more information. According to Spira (1999) are financial experts better able to interpret and understand new information. Companies can decide to add more financial experts in the audit committee, because they need to understand the language of the auditor, like the overall audit strategy, including timing of the audit and significant risks. Therefore, the first hypothesis:
Hypothesis 1a: The Auditing Standard No. 16 has a positive effect on the number of financial experts in the audit committee
Companies can also decide to replace non-financial audit committee members with audit committee members with financial expertise. Therefore the following hypothesis:
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Hypothesis 1b: The Auditing Standard No. 16 has a positive effect on the proportion of financial experts in the audit committee
With the adoption of Auditing Standard No. 16 by the PCAOB, the external auditor and the audit committee will communicate more about the activities of the audit and significant changes in the strategies and activities of the external auditor. The audit committee can use the information, about significant audit and financial statement matters, to develop their overseeing and monitoring activities. The audit committee needs to be proactive and ask probing questions about financial reporting. According to Turner (2001), there is a relation between the frequency of meetings between management and the external auditor and the quality of reporting and communication from management and external auditors. Raghunandan et al. (2003) agree with this, they find that more meetings between the audit committee and the external auditor lead to more relevant information and knowledge about the internal accounting and auditing issues. More relevant information leads to better monitoring and overseeing of the financial reporting and accounting processes. Also Spira (1999) argues that more activities between the external auditor and the audit committee enhance the reliability of the entity. According to Felo et al. (2003) is the frequency of meetings important because in this way, the audit committee is able to enquire a better understanding of the audit cycle. Arvidsson (2012) argues that the frequency of corporate communication has been increasing considerably over the last 15 years and still continues to increase; this is in line with the increase of auditing standards. Munro and Buckby (2008) agree with this, they have conducted research in Australia about the relationship between the corporate governance principles, which are adopted in 2003, and audit committee characteristics. The results of this study indicated the number of meetings has improved subsequently due the adoption of the new regulation. Ghosh et al. (2010) examined the effect of regulation on audit committee characteristics. They found, by comparing the pre-SOX and post-SOX periods, the audit committee characteristics were undergoing structural shifts because of regulatory changes. According to Jensen (1993) increases the frequency of audit committee meetings in the presence of more and new information. New auditing standards and more communication between the external auditor and the audit committee can result in more meetings to discuss the acquired information. This lead to the following hypothesis:
Hypothesis 2: The Auditing Standard No. 16 has a positive effect on the audit committee activities, by increasing the number of audit committee meetings
19 The main roles of the audit committee are overseeing and monitoring the financial reporting process and provide advice in the selection and termination of the external auditor (SOX, 2002). The audit committee has an important role to improve the quality of the financial reporting (Felo et al., 2003). As part of the mission, to protect the interest of investors and the public interest, the PCAOB has been reaching out a number of ways to the audit committees, to gather input for its activities and help them in their performance of their duties. This has been mostly done with the adoption of new, or improving existing, auditing standards. Among others, this has resulted in the adoption of Auditing Standard No. 16, which is effective since December 2012 (PCAOB, 2012). Auditing Standard No. 16 requires more communication between the audit committee and the external auditor. The standard should facilitate audit committee members of a company for the purpose of overseeing the accounting and financial reporting process of the company and audits of the financial statements of the company (PCAOB, 2012). The study of Lobo and Zhou (2006) finds a relation between auditing standards and financial reporting quality. They found that there is more conservatism in the financial reporting of firms in the two years after the adoption of the SOX act, than two years preceding the SOX act. This indicates that earnings management decreased after more regulation. Cohen et al. (2008) agrees with this, they found that the level of accrual based earnings management declined after the passage of the SOX act. Ghosh et al. (2010), which examined whether audit committee characteristics are associated with earnings management before and after the SOX act, find that earnings management declined significantly following the enactment of SOX act. The results of Lobo and Zhou (2006), Cohen et al. (2008) and Ghosh et al. (2010) indicate that earnings management decreased because of regulatory changes. More regulation and more information about significant audit and financial statement matters can improve the effectiveness of the audit committee, which can lead to a decrease in earnings management and thereby an increase in financial statement quality. This lead to the following hypothesis:
Hypothesis 3: The Auditing Standard No. 16 has a positive effect on the audit committee effectiveness, in overseeing and monitoring the financial reporting process, which leads to a decrease in earnings management
A requirement of the SOX act from 2002 is that at least one of the audit committee must have financial expertise (SOX, 2002). Many researchers support this requirement. Bedard et al. (2004) find a significant negative relation between the financial expertise of the audit committee and earnings management. They conclude that the presence of financial experts on the audit committee
20 reduces the likelihood of aggressive earnings management and thereby increases the quality of financial reporting. Felo et al. (2003) and Carcello et al. (2006) agrees with this, they found also evidence that the presence of at least one member with financial expertise is negative associated with the likelihood of aggressive earnings management. Consistent with this, Abbot et al. (2004) found a significant negative association between restatements and an audit committee that includes at least one financial expert. Furthermore, Krishnan and Visvanathan (2008) and Beasley et al. (2009) agree with this, they found that financial expertise is positive correlated with conservatism, which decreases the probability of aggressive earnings management and thereby increases the quality of financial reporting. Collectively, these studies indicate that an audit committee with more audit committee financial experts increases the financial reporting quality because of better overseeing and monitoring the financial reporting and accounting processes. The results of these studies lead to the following hypothesis:
Hypotheses 4: More financial experts in the audit committee have a positive effect in overseeing and monitoring the financial reporting and accounting processes, which leads to a decrease in earnings management
Despite the fact that the SOX act of 2002 has no requirements on the number audit committee meetings, the BRC recommended that the audit committee must have at least four meetings every year to fulfil their duty in overseeing and monitoring the financial reporting and accounting processes (BRC, 1999). Abbot et al. (2004), support the recommendation of the BRC, they found a negative relation between an active audit committee and incidences of fraud. Furthermore, Vafeas and Larmou (2010) find a negative relation between the frequency of audit committee meetings and earnings management. Another study that has investigated the relation between audit committee activities and audit quality is from Xie et al. (2003), they found also a negative relation between audit committee meetings and earnings management. Kent et al. (2010), which examined whether audit committee characteristics are associated with earnings management, find that firms exceeding the average number of meetings engage in less earnings management. Finally, Klein (2002) finds that a more active audit committee board is associated with higher financial reporting quality. Collectively, these studies indicate that a more active audit committee is positive related with financial reporting quality because of better overseeing and monitoring the financial reporting and accounting processes. The results of these studies lead to the following hypothesis:
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Hypothesis 5: More audit committee activities have a positive effect in overseeing and monitoring the financial reporting and accounting process, which leads to a decrease in earnings management
This leads to the following summary of hypotheses. The first two hypotheses are related to the effect of the adoption of Auditing Standard No. 16 on the composition and activity of the audit committee; this study will investigate if Auditing Standard No. 16 affects the number of financial experts in the audit committee and the number of meetings of the audit committee. The third hypothesis relates to the direct relation between Auditing Standard No. 16 by the PCAOB and financial reporting quality; has the standard influence on the quality of financial reporting. Finally, the last two hypotheses, hypothesis four and five, are related to the effect of these audit committee characteristics on financial reporting quality; has the number of financial experts in the audit committee and the number of audit committee meetings influence on the quality of financial reporting. Figure 1 shows an overview of the hypotheses.
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3. Research methodology
3.1. Data collection and sample selection
The empirical approach of this study conducts a quantitative research approach. The archival data, that will be used to study the effects of Auditing Standard No. 16 on the composition and activity of the audit committee and financial reporting quality, are retrieved from different databases. Annual firm data for each firm and year, in order to calculate the proxy for financial reporting quality and several control variables are retrieved from the Compustat Fundamentals Annual database. The audit committee characteristics; audit committee size, audit committee members with financial expertise and independent audit committee members are retrieved from the Institutional Shareholder Services database (hereafter ISS). The audit committee meetings, which are not available from any database, are hand collected from electronic filings of proxy statements in the EDGAR database of the SEC. All the audit committee characteristics from 2015 are not yet available from the ISS database; these characteristics from 2015 are also hand collected from the EDGAR database of the SEC. To collect the audit committee information from the EDGAR database, the DEF 14a reports are analysed. Listed firms are required to publish the DEF 14a reports, which contains information about their corporate governance, including the audit committee.
The sample of this research comprises firms in the S&P 500 index. This study focuses on the S&P 500 companies, because these companies are mandated to follow the regulations of the SEC, which indirectly means that these companies have to follow the SOX act and the Auditing Standard No. 16 from the PCAOB. To measure the effects of the standard, a comparison is been made between three years before the adoption of the standard and three years after the adoption. The Auditing Standard No. 16 is effective since the end of December 2012; this means that data is collected six consecutive years from 2010 to 2015. The initial sample from the S&P 500 from 2010 to 2015 consists of 3,217 firm-year observations. The S&P 500 is based on the market capitalization of the 500 largest companies, stock listed on the NYSE or NASDAQ. This means that companies can enter or can be removed from the S&P 500 because of market capitalization changes. Firms who entered or removed the S&P 500 during the years 2011 to 2015 are filtered to collect six consecutive years, reducing the sample to 2,752 firm-year observations. Financial institutions code 6000-6282), insurance companies code 6300-6411) and funds (SIC-code 6726) are eliminated from the sample because of their special regulatory environment (Vafeas, 2005), reducing the sample to 2,211 firm-year observations. Observations with missing data of the audit committee characteristics from the ISS are checked in the EDGAR database of
23 the SEC, with hand collection. All observations with missing data for both the ISS database and the EDGAR database are eliminated, reducing the sample to 1,740 firm-years. Furthermore, the agriculture and non-classifiable industries are taken out for account because of too less observations in these industries. After dropping these industries, the sample is reduced to 1,728 firm-year observations, representing 288 unique firms from 2010 to 2015. Table 1 presents the details of the sample selection procedure.
Table 1: Sample derivation
Number of firm observations S&P 500 from 2010 to 2015 3,217
Less: Firm-year observations who entered or removed the S&P 500 during 2011 till 2015 (465)
Less: Firm-year observations in the finance industry (2-digit SIC Code 6000 till 7000) (541)
Less: Firm-year observations with missing audit committee data from the EDGAR database (471)
Less: Firm industries with too less observations (12)
Final sample (2010-2015) 1,728
Final unique firms (2010-2015) 288
Note: This table reports the sample selection procedure. The initial sample consist of 3,217 firm-years observations, the final
sample is reduced to1,728 firm-years observations, representing 288 unique firms from 2010 to 2015.
3.2. Dependent variable
Consistent with prior literature (e.g. Xie et al., 2003; Berard et al., 2004; Krishnan and Visvanathan, 2008; Ghosh et al., 2010), this study uses earnings management as proxy to measure financial reporting quality. To obtain earnings management the discretionary accruals are estimated, which are calculated with the Modified Jones Model from Dechow et al. (1995). Dechow et al. (1995) have modified the Jones Model from 1991 to provide the most powerful model to detect earnings management. The most important difference between the Jones model (1991) and the Modified Jones Model (1995) is that the change in revenue is adjusted for the change in receivables. The Modified version is designed because Dechow et al. (1995) state that it is easier to manage earnings over the recognition of revenues in credit sales than in cash sales. Accounting fundamentals are used to separate the total accruals into two components: the nondiscretionary (normal) and discretionary (abnormal) accruals. The absolute value of the abnormal components determines the quality of the earnings (Dechow et al., 1995); higher discretionary accruals result in lower financial reporting quality. The discretionary accruals (abnormal accruals) will be measured as follows:
24 𝐷𝐴𝜏 = 𝑇𝐴𝜏 − 𝑁𝐷𝐴𝜏
Where:
DAt = Discretionary accruals in current year
TAt = Total accruals in the current year
NDAt = Non-discretionary accruals in current year
The first step to measure the discretionary accruals is to calculate the total actual accruals. The total actual accruals are calculated with a balance sheet approach and are scaled by the total assets of the previous year, to control the different firm sizes (Dechow et al., 1995). The following model is used to calculate the total accruals:
𝑇𝐴𝜏 = [(∆𝐶𝐴𝜏 − ∆𝐶𝐿𝜏 − ∆𝐶𝐴𝑆𝐻𝜏+ ∆𝑆𝑇𝐷𝜏− 𝐷𝐸𝑃𝜏)/𝐴𝜏−1]
Where:
∆CAt = Total change in current assets
∆CLt = Total change in current liabilities
∆CASHt = Total change in cash and cash equivalents
∆STDt = Total change in debt included in current liabilities
DEPt = Depreciation and amortization expense
At-1 = Total assets in the previous year
Second, a cross-sectional regression analysis is made of the groups per industry, see table 2 for the industry groups, to estimate the values of the firm specific parameters. Using the model:
(𝑇𝐴𝜏 𝐴𝜏−1) = 𝛼0+ 𝛼1( 1 𝐴𝜏−1) + 𝛼2[ (∆𝑅𝐸𝑉𝜏− ∆𝑅𝐸𝐶𝜏) 𝐴𝜏−1 ] + 𝛼3( 𝑃𝑃𝐸𝜏 𝐴𝜏−1) + 𝜀𝑡 Where:
∆REVt = Revenues in the current year less the revenues in the previous year, scaled by the total assets in the previous year
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∆RECt = Net receivables in the current year less net receivables in the previous year, scaled by the total assets in the previous year
PPEt = Gross property plant and equipment in the current year, scaled by the total assets in the previous year
α1, α2, α3 = Firm-specific parameters
𝜀𝑡 = Residual term
Third, with the firm-specific parameters from the above model the estimation of the non-discretionary accruals are measured, which is calculated with the following model:
𝑁𝐷𝐴𝜏 = 𝛼0+ 𝛼1( 1 𝐴𝜏−1) + 𝛼2[ (∆𝑅𝐸𝑉𝜏− ∆𝑅𝐸𝐶𝜏) 𝐴𝜏−1 ] + 𝛼3( 𝑃𝑃𝐸𝜏 𝐴𝜏−1) + 𝜀𝑡
Finally, the discretionary accruals are measured. The absolute differences between the total accruals and the estimated non-discretionary accruals, is the discretionary accruals part of the total accruals:
𝐷𝐴𝜏 = 𝑇𝐴𝜏 − 𝑁𝐷𝐴𝜏
The discretionary accruals are the difference between firms’ actual accruals and the normal level of accruals; in other words, the portion of unexplained accruals. This is shown as the residual term. Based on previous research (Ghosh et al., 2010), this study will use the absolute value of discretionary accruals to measure financial reporting quality; a higher proportion of the absolute value of discretionary accruals result in lower financial reporting quality. The modified Jones model is a cross-sectional model; therefore the accruals will be calculated per industry group, which is categorized by the two-digit Standard Industrial Code (hereafter SIC) industry codes from the SEC. Table 2 presents the unique firms per industry.
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Table 2: Sample distribution by 2-digit SIC industry
Industry sector 2-SIC code Frequency
Agriculture, forestry, Fishing 01-09 6
Mining 10-14 138
Construction 15-17 30
Manufacturing 20-39 852
Transportation & Public Utilities 40-49 306
Wholesale Trade 50-51 42 Retail Trade 52-59 156 Services 70-89 204 Public Administration 91-98 0 Non classifiable 99-99 6 Total 1,740
Notes: Agriculture, public administration and non-classifiable industry sectors are filtered because of too less observations
in their industry sector, reducing the sample to 1,728 observations.
3.3. Independent and control variables
The dependent variable, earnings management as proxy for financial reporting quality, can be influenced by many factors relating to corporate governance. One of the most important influences is the audit committee. According to Xie et al. (2003) plays the audit committee a direct role in controlling earnings management. The audit committee is a broad term and is therefore broken down to the important elements of the composition and activity of the audit committee, these are audit committee expertise, audit committee activity, audit committee size and audit committee independence. Audit committee expertise and audit committee meetings will form the independent variables, given that this study limits itself to audit committee members with financial expertise and audit committee activity. The audit committee size of the firm and the proportion of independent members in the audit committee will be control variables. Other important control variables that can influence the financial reporting quality are the size of the firm, growth of the firm, the audit firm who audits the firm, firm leverage, the return on assets and losses. This study explores the effects of the Auditing Standard No. 16 by the PCAOB on the composition and activity of the audit committee and on the quality of financial reporting, using the following regression model:
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DAt = β0 + β1ACexp + β2ACmeet + β3ACsize + β4ACind + β5Size + β6Growth + β7Big4 + β8Lev + β9ROA + β10Loss
Where:
DAt = Discretionary accruals in the current year, scaled by total assets
ACexp = Audit committee financial expertise, number of members on the committee with financial expertise
ACmeet = Audit committee meetings, number of meetings of the committee in each year ACsize = Audit committee size, number of members on the committee
ACind = Proportion of independent members in the audit committee Size = Size of the firm, measured by natural logarithm of total assets
Growth = Growth of the firm, total assets at the end of the financial year divided by the total assets at the beginning of the financial year
Big4 = Audit company, measured by a dummy variable: is the firm audited by a big-four company or not
Lev = Proportion of leverage, measured by ratio of total liabilities to the total assets ROA = Return on assets, measured as ratio of net income to total assets
Loss = Losses, measured by dummy variable; has the firm booked a loss or a profit
The first independent variable of the regression model is the financial expertise of the audit committee. The number of audit committee members with financial expertise will measure this. The SOX act requires that every audit committee must have a member with financial expertise. Earlier research shows that financial expertise is positive associated with financial reporting quality (Abbot et al., 2004; Xie et al., 2003; Bedard et al., 2004).
The second independent variable is audit committee activity. This will be measured with a continuous variable; the number of audit committee meetings. Even though the SOX act has no guidelines towards the frequency of audit committee meetings, previous research found a significant negative relation between audit committee activity and financial reporting quality (Abbot et al., 2004; Xie et al., 2003).
The first control variable is the audit committee size; this will be measured with a continuous variable. The Blue Ribbon Committee (1999) recommended that the audit committee must have at least three members to oversee and monitor the financial reporting processes. Abbot et al. (2004) found a significant positive relation between audit committee size and financial
28 reporting quality. The audit committee must exist of sufficient members to uncover and resolve potential problems.
The second control variable is audit committee independence. This will be measured with a ratio of the proportion of independent members to the total audit committee members. According to Bedard et al. (2004) there is a significant reduction in the likelihood of aggressive earnings management when all the audit committee members are independent. Independent members are better able to maintain their objectivity (Klein, 2002).
The third control variable is firm size. This will be measured by the natural logarithm of total assets. Klein (2002) found a negative relation between firm size and financial reporting quality. It is more likely that smaller firms use more earnings management because they are less scrutinized by authorities (Xie et al., 2003). Menon and Williams (1994) argue that smaller firms have fewer incentives to maintain an active board because of high expenses; larger firms can benefit from an active board because of economies of scale in overseeing and monitoring the financial reporting processes.
The fourth control variable is firm growth. The growth of a firm will be measured by the current book value minus the book value at the beginning of the financial year, divided by the book value of the assets at the beginning of the financial year. According to DeFond and Subramanyam (1998) there is a negative relation between firm growth and earnings management. Growing firms have litigation-based reasons for making less aggressive accounting choices. If a firm grows they have to deal with uncertainties, this can be an incentive for the audit committee to be more active and to meet more often.
The fifth control variable is the auditor of the firm. There is a negative relation between the big audit firms and earnings management, big audit firms are successful in detecting earnings management (Becker et al., 1998). The quality of the audit is higher by large audit firms than by small audit firms because big audit firms are less dependent on the fees that they could lose when they need to issue a going-concern report (DeAngelo, 1981). This variable will be measured as a dummy variable, valued with 1 if the firm is audited by a big four company and valued 0 if not.
The sixth control variable is leverage. Leverage is defined as the ratio of total liabilities to total assets. Managers have incentives to manage their earnings if the firm has to meet the conditions of their debt covenants (Beatty and Weber, 2003). According to DeFond and Jiambalvo (1994) there is a positive relation between the proportion of leverage and the incentives to manage earnings. Leverage ratio can influence the accounting choices of companies; companies that have to meet debt covenant agreements are more likely to engage in earnings management (Watts & Zimmerman, 1990). Firms should be more likely to maintain an active audit committee if they
29 have a high leverage ratio (Menon and Williams, 1994).
The seventh control variable is return on assets. The return on assets is included as control variable to control the potential changes in firm performance. Return on assets reflects how efficiently the assets are being utilised. According to Baxter and Cotter (2009) there could be a relation between earnings quality and firm performance. Kothari et al. (2005) found evidence that companies with bad performance are more likely to engage in earnings management. Firms with a higher return on assets have fewer incentives to engage in earnings management. The variable will be measured as the ratio of net income to total assets.
The eighth and final control variable is loss. This variable will be measured as dummy variable, valued with 1 if the firm booked a loss and 0 otherwise. Loss is included as control variable because firms in distress higher incentives have to exercise their discretion to manage the earnings (Defond and Subramanyam, 1998).
Table 3 gives a summary of the variables included in the regression model and their expected relation with financial reporting quality:
Table 3: Variable description
Variable Expected influence on financial reporting quality
Audit Committee Experts +
Audit Committee Meetings +
Audit Committee Size +
Audit Committee Independence +
Firm size +
Growth of the firm +
Audited by a big four audit-firm +
Leverage -
Return on Assets +
Losses -
Note: This table report the expected relation between the variables and earnings management, as proxy of financial
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3.4. Empirical design
To answer the research question, this study will test five hypotheses. This study investigates whether the audit committee expertise and audit committee activity changed following Auditing Standard No. 16. This will be tested with the first two hypotheses. These hypotheses relates to the change of audit committee members with financial expertise and the change of audit committee meetings, after the adoption of Auditing Standard No. 16 by the PCAOB. The number of audit committee experts and audit committee meetings in the pre-period (i.e. 2010 to 2012) will be compared with the post-period (i.e. 2013 to 2015). The differences between both periods will be tested with absolute values from descriptive statistics and with a two-sample t-test with equal variances, to test if the differences between the absolute values are significant.
This study investigates also whether the overall earnings management declined following Auditing Standard No.16. The third hypothesis relates to the increase of financial reporting quality because of the adoption of Auditing Standard No. 16 by the PCAOB. The Modified Jones Model from Dechow et al. (1995) is used in order to measure earnings management, as proxy for financial reporting quality. Descriptive statistics will measure the change in earnings management between the pre-period (i.e. 2010 to 2012) and the post-period (i.e. 2013 to 2015). The two-sample t-test with equal variances will indicate if the change in earnings management is significant.
Finally, this study investigates whether the audit committee expertise and audit committee activity is associated with earnings management and whether there was a shift in this relationship for the years following Auditing Standard No. 16. The fourth and fifth hypothesis, related to the increase of financial reporting quality because of more audit committee members with financial expertise and more audit committee meetings will be measured with regression analysis. The regression model will test the relation between the absolute value of discretionary accruals and the different audit committee characteristics. Finally, an additional regression will provide insights if the mandated communication between the audit committee and the external auditor has led to a change in the relation between audit committee characteristics and earnings management.
To minimize the effects of extreme observations, the bottom and top one per cent of the total accruals, the non-discretionary accruals and the control variables; firm growth, firm leverage, firm size and return on assets are winsorized to the values of the 1st and 99th percentiles. After that, the process of fitting a regression model of Field (2013) is used to conduct the regression analysis. The scatterplots are produced to see if the assumptions are linear and to look for any outliers or unusual cases. The assumptions are linear, resulting that these data did not have to be transformed. Finally, the residuals are checked for homoscedasticity, normality and independence. The pattern of the model indicates that the assumptions of linearity and homoscedasticity have been met.
