Earnings management and the board process: the impact of the status of the CEO on the monitoring function of a financial expert in the board of directors.

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Earnings management and the board process: the impact of the status

of the CEO on the monitoring function of a financial expert in the

board of directors.

University of Groningen

Master thesis Accountancy

Name: Dennis Boer

Student number: 2018969

Supervising lecturer: dr. D. B. Veltrop Co-assessor: dr. R. C. Trapp

Date: 20-06-2017

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Abstract

This study examines the effect of having a financial expert in the board of directors on the degree of earnings management. It also examines whether the social status of the chief executive officer (CEO) has influence on this relationship. This is motivated by the Sarbanes Oxley Act (SOX), which requires organizations to disclose about whether they have a financial expert in the board of directors, and the prior research that found social status has influence on the interactions between group members. This research contributes to prior research by measuring financial expertise by self-report and by examining the influence of the social status of the CEO. Using the Modified Jones Model, the relationship between a

between a financial expert in the board of directors and the degree of earnings management is examined. The results of this analysis show a not significant negative relationship. Also the moderation effect of the social status of the CEO is tested, but no significant result was found. These results suggest that having a financial expert in the board of directors not always leads to less earnings management and that the social status of the CEO has no impact on the functioning of the financial experts in the board of directors.

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2.3 Financial expertise ... 8 2.4 Social status ... 10 3. Research design ... 12 3.1 Sample ... 12 3.2 Independent variable ... 12 3.3 Dependent variable ... 13 3.5 Control variables... 14 3.6 Analytical methodology ... 15 3.7 Analysis of variance... 16 4. Results ... 17 5. Additional analysis ... 21

5.1 Abnormal working capital accruals ... 21

5.2 Organizations with audit committee ... 22

5.3 Higher status of the CEO than the financial expert ... 23

6. Conclusion and discussion ... 24

6.1 Answer to the research question ... 24

6.2 Theoretical implications ... 25

6.3 Practical implications... 26

6.4 Limitations and directions for future research ... 26

References ... 28

Appendix 1: Abnormal working capital accruals ... 34

Appendix 2: Audit committee ... 36

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1. Introduction

Several studies show that executives engage in earnings management for various reasons as increasing management compensation, reducing the likelihood of violating lending

agreements or to manage earnings losses and decreases away to decrease transaction cost with stakeholders (Healy & Wahlen, 1999; Burgstahler & Dichev, 1997; Bergstresser &Philippon, 2006). This leads to a problem, because earnings management gives stakeholders false information (Xie et al., 2003) and thereby the stakeholders will get a wrong impression of the functioning of the organization (Healy & Wahlen, 1999). Given the board of directors’ fiduciary responsibility to monitor and discipline the management to ensure that management will act in the best interest of the stakeholders (Healy & Palepu, 2001), boards of directors play an important role in ensuring that management does not engage in earnings management (Richardson, 2000; Peasnell et al., 2005; Rahman & Ali, 2006).

In response to corporate scandals in which organizations misreported their earnings, regulators stress the importance of financial expertise of non-executives in the board of directors. For instance, the Sarbanes Oxley Act (SOX) requires companies to have an audit committee and to disclose whether they have at least one financial expert on it’s audit committee or the fact that the company does not have a financial expert and explain why it has no such expert (SEC, 2003a). Accounting and certain types of non-accounting financial expertise reduce earnings management for firms with weak alternate corporate governance mechanisms (Carcello et al, 2006). In addition, Klein (2002) found a negative relationship between audit committee independence, which oversees the financial process, and abnormal accruals. Finally, Xie et al. (2003) found that the proportion outside directors with a corporate background, who are likely to be more financially sophisticated, has a negative impact on earnings management. The evidence, to date, suggests that financial expertise within boards is important for reducing earnings management.

Nevertheless, despite of the importance of financial expertise in reducing earnings management, the presence of financial expertise in the board of directors does not

automatically result in this expertise being used (Veltrop et al., 2017). Research, however, assumes that appointing financial experts to boards, also equips these directors to influence board decisions (Hillman & Dalziel, 2003). The board of directors is a human

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decision-decisions of the management (Fama & Jensen, 1983). This means the decision-making process is important. Wan & Ong (2005) conclude that board process seems to play a more important role than board structure on the board performance. Whereby board process consists of the decision-making activities of directors of companies. They stress that a direct relationship between board characteristics and the board performance cannot be assumed. So a financial expert in the board of directors is no guarantee for better board performance, this very much depends on the board processes operating within the board (see also Finkelstein & Mooney, 2003; Forbes & Milliken, 1999). However, board processes are treated as a black box, because of the limited access in observing the board processes.

Boards do not operate in isolation of the chief executive officer (CEO); they need to monitor the CEO (Fama & Jensen, 1983). Hereby, the social status of the CEO may play a crucial role. The CEO can get a higher status because of his important position in the organization (Pearce & Robinson, 1987). With a high status, people are allowed to control group

interactions, make decisions for the group and give verbal directives to other members of the group (Anderson et al, 2006). It does not matter if the CEO is not a member of the board of directors, because social status can be an intergroup phenomenon (Magee & Galinsky, 2008). Magee & Galinsky (2008) indicate that a social hierarchy exists as long as there is

differentiation across individuals or groups on any valued dimension. A social hierarchy is also important within boards, because it influences the interactions between the directors and thereby has implications on the effectiveness of the board (He & Huang, 2011). Therefore, the social hierarchy can be considered as an important board process. Financial expertise may affect the status, because expertise may lead to respect of the other directors and thereby lead to a higher social status (Magee & Galinsky, 2008). However, it does not automatically lead to the highest status, because a social hierarchy is a ranking and another director can have a higher rank in the eyes of others (He & Huang, 2011). This could mean that the status of the CEO may reduce the effect of a financial expert in the board, because financial experts without status are unlikely to be influential during board meetings.

This study contributes to the existing literature by demonstrating that the status of a CEO is an important moderating factor for the relationship between financial expertise and earnings management. Furthermore, by conducting a survey with all directors of many boards of directors of Dutch non-profit organizations, a unique dataset is used to examine the effect of financial expertise in the board on earnings management and the moderating effect of status.

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So this paper builds on the results of Wan & Ong (2005) and Finkelstein & Mooney (2003) and creates a better understanding of the inner workings of the board of directors.

The goal of this study is to gain insight into the effect of having a non-executive financial expert in the board of directors on the degree of earnings management. Because of the boards do not operate in isolation from the CEO; the impact of the financial expert probably depends on the social status of the CEO. Therefore, the moderating effect of the social status of the CEO on the influence of the financial expert is examined. This leads to the following research question: Does having a non-executive financial expert in the board reduce earnings

management and how does the social status of the CEO affect this relationship? A study on board of directors is conducted to answer this research question.

The next section of this paper provides more information about the relations between the variables and discusses the hypotheses. The third section describes the research design. The results are presented in section four and section five presents the additional analysis. Finally, there is a conclusion and discussion.

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2. Background and hypotheses development

This chapter provides an overview of the existing literature about earnings management, the role of the board of directors in preventing earnings management, financial experts and social status. Furthermore, two hypotheses are developed based on the existing literature.

2.1 Earnings management

Managers use earnings management to meet expectations and this gave investors false information (Xie et al., 2003). In addition, Healy & Wahlen (1999) defined earnings

management as the alteration of firms’ reported economic performance by insiders to either mislead some stakeholders or to influence contractual outcomes. Furthermore, Leuz et al. (2003) defined that earning management is a way to mask the private control benefits of the management and it reduces the likelihood of outside intervention by managing the level and variability of reported earnings. Managers can engage in earnings management by using both real operating decisions and financial reporting choices (Leuz et al., 2003).

Managers have several incentives to engage in earnings management. Graham et al. (2005) found that managers use earnings management to meet or beat the benchmarks for several reasons like improving their reputation or to maintain or increase the stock price. According to Burgstahler & Dichev (1997), firms exercise earnings management when there are small earnings decreases or slightly negative earnings. By managing the cash flow from operations or the working capital, the results become positive. Furthermore, Healy & Wahlen (1999) found that firms engage in earnings management when they anticipate reporting a loss, reporting an earnings decline or falling short of investor’s expectations. Managers engage in earnings management for reasons like influence stock market perceptions, increasing

management compensation and avoiding of violating lending agreements (Healy & Wahlen, 1999). Non-profit organizations also engage in earnings management. When an organization incurs losses, a manager has incentives to increase the earnings in order to reduce the cost of debt. Further, when an organization makes profit, a manager has the incentive to decrease the earnings, because a high profit would cause in a greater level of scrutiny (Tan, 2011). So there are various reasons for organizations to engage in earnings management, but these reasons are all in the interest of the manager.

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The consequence of using earnings management, when the financial situation continues to deteriorate, is that it can lead to big write-offs or large negative surprises in future periods (Graham et al., 2005). This means that the management takes additional risk with the money of their investors for their own interest. Gunny (2005) did research to the consequences of real earnings management en concluded that real earnings activities negatively affect future

operating activities. Real earnings activities are associated with lower cash flows and a lower return on assets (ROA). This results in inflating stock prices, which later fall as the less favorable earnings information arrives (DuCharme et al., 2004). Furthermore, many people find earnings management ethically objectionable (Chih et al., 2008). So many stakeholders will be disappointed when the organization engages in earnings management. In conclusion, it must be ensured that the manager will not engage in earnings management.

2.2 Role of the board of directors

The function of the board of directors is to monitor the decisions of the management (Fama & Jensen, 1983). According to Healy & Palepu (2001), the board of directors is a mechanism for reducing agency problems, because their role is to monitor and discipline management on behalf of external owners. Because of the negative consequences of earnings management on stakeholders, the board has to monitor the management to ensure the management will not engage in earnings management.

An incentive for using earnings management by the management is information asymmetry. A higher level of information asymmetry between the management and the stakeholders leads to a higher degree of earnings management, because stakeholders don’t have enough relevant information to monitor the actions of the management when there is a high level of

information asymmetry (Richardson, 2000). The board of directors has to monitor and report about the performance of the organization. When they monitor and report successful, the level of information asymmetry will be reduced (Richardson, 2000). Furthermore, Peasnell et al. (2005) conclude that the proportion of outside directors have a negative influence on the degree of earnings management. These outside directors contribute primary to the monitoring role, because they have no significant relationship with the company beyond being directors (Faleye et al., 2011; Kim et al., 2014). So monitoring by the board of directors is important in ensuring the management will not engage in earnings management.

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2.3 Financial expertise

Early 2000s, organizations like Enron and WorldCom entered bankruptcy proceedings in the wake of revelations of fraudulent accounting practices (Romano, 2005). For example, Enron used special purpose entities to achieve financial reporting objectives. Enron was able to avoid consolidating these special purpose entities and this resulted in underestimated

liabilities and overestimated equity and earnings (Healy and Palepu, 2003). This resulted in a decreasing stock price and finally in bankruptcy for Enron in 2001. In response to these accounting scandals, in 2002 the SOX was introduced in the United States. The act contains significant changes in management reporting responsibilities and the responsibilities of the auditor (Zhang, 2007). According to Zhang (2007), the act prevents fraudulent accounting and management behavior by requiring more oversight, imposing greater penalties and dealing with potential conflicts of interest. More oversight is created by a mandatory audit committee and requiring companies to to disclose whether they have at least one financial expert on it’s audit committee or the fact that the company does not have a financial expert on it’s board and explain why it has no such expert (SEC, 2003a). Whereby an Audit committee is defined in the SOX (2002) 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”. So it is likely that members of the Audit committee have knowledge of financial reporting. Klein (2002) confirmed this, because she found a negative relationship between audit committee independence and abnormal accruals. However, a sample of publicly traded U.S. firms before the SOX was used for this study. So at least one financial expert in the board of directors was not required. On the other hand, Xie et al. (2003) studied the effect of financial expertise in audit committee and found a negative relationship with earnings management.

The SOX (2002) defined someone as a financial expert based on that persons education or working experience. Furthermore, a financial expert is someone who understands and has experience in applying the general accepted accounting principles (GAAP), has experience in preparing or auditing financial statements and has experience with internal controls and procedures for financial reporting (Sec, 2003a). In the existing literature, financial expertise is often measured by using working experience as proxy. Carcello et al. (2006), Custodio & Metzger (2014) and Rosenstein &Wyatt (1997) all defined a financial expert as someone who has experience as accountant, chief financial officer, vice president of finance etc. In contrast to other studies, Dhaliwal et al. (2006) dived financial expertise in accounting, finance, or

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supervisory expertise and measured the effect of these three categories. For a financial expert of the category accounting, Dhaliwal et al. (2006) used the same working experience as proxy earlier mentioned researches did. Financial expert of the category finance is measured by using working experience as investment banker or financial analyst and supervisory expertise by using working experience as CEO and company president. Based on the definition and the used proxies in the existing literature, it can be expected that a financial expert performs better in recognizing earnings manipulation than directors who has no financial expertise. A financial expert has through his working experience and education more knowledge about the accounting principles, financial statements and internal controls, which may help to recognize forms of earnings manipulations. Furthermore, the other directors are more likely to go along with the findings of the financial expert, because of his education and working experience. Bédard et al. (2004) found evidence for the requirements of the SOX, because they concluded that the presence of at least one financial expert in the audit committee results in a lower likelihood of aggressive earnings management. Beside this conclusion, Carcello et al. (2006) found that accounting and certain types of non-accounting financial expertise reduce earnings management for firms with weak alternate corporate governance mechanisms. In addition, they found independent audit committee members with financial expertise are most effective in reducing earnings management. Additionally, Xie et al. (2003) found that an audit

committee is associated with reduced levels of earnings management when it contains

members with a financial or corporate background. In contrast to those studies, Dhaliwal et al. (2006) only found a significant positive relation between accounting expertise and the

accruals quality. They found no significant association between the accruals quality and finance or supervisory expertise.

In conclusion, the SOX requires organizations to have an audit committee with at least one financial expert to prevent fraudulent accounting. Furthermore, several studies found that a director with financial expertise may affect the degree of earnings management. So I expect that at least one non-executive financial expert in the board of directors has a negative impact on the degree of earnings management. This expectation leads to the following hypothesis:

H1: The presence of at least one non-executive financial expert in the board of

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2.4 Social status

Raheja (2005) did a research to the interaction between inside directors and outside directors in a corporate board. Raheja concluded the optimal board structure dependents of the ability of outside directors to reject inferior projects. Raheja (2005) shows that the CEO can

influence outside directors to vote for a bad project, even when the board verified the proposed project is a bad project. A reason for this may be the social status of the CEO, because members with a high status are allowed to control group interactions, make decisions for the group and give verbal directives to other members of the group (Anderson et al., 2006). Whereby Anderson et al. (2006) describe status as “the prominence, respect and influence individuals enjoy in the eyes of others” (p. 1094). This could mean that a CEO with a high status can influence the directors of the board, which may lead to a less effective monitoring function executed by the board of directors. A CEO can get this high status because of his important position in the organization, the CEO is the leader in the organizational hierarchy, or due the expertise and knowledge of the CEO in the eyes of others (Pearce & Robinson, 1987).

Badolato et al. (2014) examined the influence of the status of the audit committee and

financial expertise constraining earnings management. Badolato et al. (2014) defined status as “an individual's ability to influence outcomes based on perceived skills, qualities and personal attributes” (p. 208). They found that adding financial experts in the audit committee without considering status is not effective in decreasing earnings management. So status may be an important factor for the functioning of the board of directors. Furthermore, He & Huang (2011) conclude that an informal hierarchy of board members has implications on the effectiveness of the board, because an informal hierarchy has influences on the interactions between the directors. An informal hierarchy can be defined as a hierarchy that develops spontaneously and rapidly and may be based on individuals’ judgments about others competence and power (Magee & Galinsky, 2008). If a CEO has the highest rank in the informal hierarchy, the CEO has more capacity to influence the other directors and may act in his/her own interest (He & Huang, 2011).

A related mechanism to social status is power, because power ensures that people can

influence other people and it is together with social status one of the most important bases of a social hierarchy (Galinsky et al., 2008). People with more power also speak more in social interactions (Anderson & Berdahl, 2002), this is consistent with status, which allowed people

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to control group interactions (Anderson et al., 2006). Combs et al. (2007) found that CEO power has a moderating effect on the relationship between board composition and firm performance. This means that a social hierarchy may be an important factor for the functioning of the board of directors.

In conclusion, it can be assumed that a social hierarchy has influence on the group

interactions. Based on prior research, it can be expected that status is an important factor for the functioning of the board of directors. So I expect when a CEO has a high status, the effect of financial expertise in the board of directors will be less effective. A CEO with a high status can easier explain away their actions about earnings management, because directors with a high status have more influence on the behavior of the other directors than directors with a lower status have. Because of this, the directors are less likely to take actions against them. This leads to the second hypothesis:

H2: The social status of the CEO will moderate the relationship between the presence

of a financial expert in the board and earnings management; such that the relationship is weaker when the social status of the CEO is high.

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3. Research design

This chapter describes the research design of this research. First, the used sample is described. Then it is explained which proxies are used for the different variables and how the proxies are measured. Thereafter the analytical methodology is described and finally the results of the analysis of variance are shown and interpreted.

3.1 Sample

This study relies on the data directly gathered from board of directors and the annual reports of Dutch non-profit organizations. These non-profit organizations include housing

corporations, educational institutions, care institutions and associations. The total sample consists of 117 Dutch organizations and includes results from surveys and archival data. There have been surveys with all members of the board of directors of all the organizations in the sample. This survey data is gathered via an online tool that boards use for their self-evaluation. Furthermore, financial information is gathered from the annual reports of the different organizations.

3.2 Independent variable

To measure the financial expertise of non-executive members of the board of directors, a survey is conducted. Each individual rated their level of expertise in the subject’s corporate finance, financial reporting, management accounting and treasury. The individuals had to answer on a 7-point answer scale (1 = no expertise, 7 = a lot of expertise). The scale was highly reliable (α = .94). Expertise is intra-personal and cannot be directly observed by others (Bunderson, 2003). To assess the degree of expertise of other members, members have to rely on indirect cues. Since expertise is first and foremost an intra-personal construct a self-report expertise measure is preferable over archival or other-rated measures of expertise (Veltrop et al., 2017).

The SOX requires at least one financial expert in the audit committee and several studies show evidence of a lower degree of earnings management by having at least one financial expert in the board of directors. So for this study, only the highest rating within every board is of interest.

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3.3 Dependent variable

Earnings management can be done by real and accrual-based earnings management activities. Real earnings management activities are activities to increase income that deviate from normal business practices (Cohen & Zarowin, 2010). Accrual-based earnings management is achieved by changing the accounting methods or estimates used when presenting a given transaction in the financial statements (Zang, 2012). As in the studies of Xie et al. (2003) and Peasnell et al. (2005), abnormal accruals used as proxy for earning management.

The modified Jones model is used to measure the abnormal accruals (Dechow et al. 1995). The Jones model is not used because in the modified Jones model is an adjustment made for the change in receivables, which can be managed by the management (Dechow et al. 1995). Firstly the total accruals are measured with the following formula:

𝑇𝐴𝐶𝐶𝑡 = ∆𝐶𝐴𝑡 − ∆𝐶𝐴𝑆𝐻𝑡 − ∆𝐶𝐿𝑡 − ∆𝐷𝐶𝐿𝑡 − 𝐷𝐸𝑃𝑡 𝐴(𝑡 − 1)

Where TACCt = the total accruals in year t, ΔCAt = the change in current assets in year t, ΔCASHt = the change in cash and cash equivalents in year t, ΔCLt = the change in current liabilities in year t, ΔDCLt = the change in short term debt included in current liabilities in year t, DEPt = the depreciation and amortization expense in year t and A(t - 1) = total assets in year t -1.

Then the modified Jones model is estimated with the following formula:

𝑁𝐷𝐴𝐶𝐶𝑡 = ∝₁ 1

𝐴(𝑡 − 1)+ ∝2 (∆𝑅𝐸𝑉𝑡 − ∆𝑅𝐸𝐶𝑡) +∝3 (𝑃𝑃𝐸𝑡)

Where NDACCt = non discretional accruals in year t, A(t – 1) = the total assets in year t -1, ΔREVt = the revenues in year t less revenues in year t -1, ΔRECt = delta net receivables in year t less delta net receivables in year t – 1 and PPEt = gross property plant and equipment in year t. The α1, α2 and α3 are firm specific parameters, which can be measured by an OLS

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𝑇𝐴𝐶𝐶𝑡 = ∝₁ 1

𝐴(𝑡 − 1)+ ∝2 (∆𝑅𝐸𝑉𝑡 − ∆𝑅𝐸𝐶𝑡) + ∝3 (𝑃𝑃𝐸𝑡) + 𝑉𝑡 Finally the discretionary accruals are calculated with the formula:

𝐷𝐴𝐶𝐶𝑡 = 𝑇𝐴𝐶𝐶𝑡 − 𝑁𝐷𝐴𝐶𝐶𝑡

The results of this formula indicate the degree of earnings management. A higher amount of discretionary accruals means a higher degree of earnings management.

3.4 Moderating variable

The data of the status of the CEO is also be obtained by a survey with board members. For this variable peer-rated questions were asked. Each non-executive had to rate the CEO on his/her competence, influence on decisions, respect and influences on themselves. They had to answer on a 7-point answer scale (1 = no status, 7 = high status). The scale is reliable (α = .77). For this moderating variable a peer-rating measure is used, because of status exist entirely only in the eyes of others (Magee & Galinsky, 2008).

3.5 Control variables

Some control variables are included in the analysis, because these variables may also affect the degree of earnings management. The used control variables are firm size, firm

performance, board meetings, leverage and the presence of an audit committee.

Firm Size

Firm size is controlled as in the studies of Xie et al. (2003) and Bergstresser & Philippon (2006), because firm size may have some impact on the degree of earnings management. According to Reynolds & Francis (2000), smaller firms are more engaged in earnings

management than bigger firms. The log of the total assets of the beginning of the year is taken for measuring the firm size (Klein, 2002).

Firm performance

Firm performance may be correlated with the degree of earnings management (Dechow et al., 1995). Therefore, it is important to control for firm performance. Firm performance is

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measured by the income divided by the total asset of last year (Roychowdhury, 2006). This is the return on assets (ROA).

Board meetings

Xie et al. (2003) found that a more active board, proxied by the number of board meetings in a year, is associated with a lower degree of earnings management. Therefore, the number of board meetings is used as control variable in this study. This data is obtained from the report of the supervisory board of all organizations in the sample.

Leverage

The presence of debt is associated with real earnings manipulations (Roychowdhury, 2006). To control for this, leverage is used as control variable. The leverage of a firm is measured by the total debt divided by the total assets of last year (Ali & Zhang, 2015).

Presence of an audit committee

An audit committee has to oversee the financial and accounting processes of the organization. In addition, Klein (2000) found a negative relationship between the independence of an audit committee and earnings management. Since not every organization of the sample has an audit committee, it is used as control variable. A dummy variable is used to control for when a firm reports has an audit committee or not.

3.6 Analytical methodology

First, the correlation between all the used variables was analyzed by conducting a correlation analysis. The correlation analysis gives an indication which variables are correlated to each other and how they are related. After that, a regression analysis is conducted to analyze the relationship between the financial expertise of non-executives in the board of directors and the degree of earnings management of the organization. The regression formula is as follows:

𝐷𝑖𝑠𝑐𝑟𝑒𝑡𝑖𝑜𝑛𝑎𝑟𝑦 𝑎𝑐𝑐𝑟𝑢𝑎𝑙𝑠

= ∝1+∝2 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙𝐸𝑥𝑝𝑒𝑟𝑡𝑖𝑠𝑒 +∝3 𝐹𝑖𝑟𝑚𝑆𝑖𝑧𝑒 +∝4 𝐹𝑖𝑟𝑚𝑃𝑒𝑟𝑓𝑜𝑟𝑚𝑎𝑛𝑐𝑒

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Finally, the moderation effect the social status of the CEO on the relationship between the financial expertise of non-executives in the board of directors and the degree of earnings management of the organization is analyzed. A regression analysis has been performed to analyze this. The formula of this regression is:

= ∝₁+∝₂ 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙𝐸𝑥𝑝𝑒𝑟𝑡𝑖𝑠𝑒 +∝₃ 𝑆𝑡𝑎𝑡𝑢𝑠𝐶𝐸𝑂 +∝₄ (𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙𝐸𝑥𝑝𝑒𝑟𝑡𝑖𝑠𝑒

∗ 𝑆𝑡𝑎𝑡𝑢𝑠𝐶𝐸𝑂) +∝5 𝐹𝑖𝑟𝑚𝑆𝑖𝑧𝑒 +∝6 𝐹𝑖𝑟𝑚𝑃𝑒𝑟𝑓𝑜𝑟𝑚𝑎𝑛𝑐𝑒

+∝₇ 𝐵𝑜𝑎𝑟𝑑𝑀𝑒𝑒𝑡𝑖𝑛𝑔𝑠 +∝₈ 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 +∝₉𝐴𝑢𝑑𝑖𝑡𝐶𝑜𝑚𝑚𝑖𝑡𝑡𝑒𝑒 + 𝜀

3.7 Analysis of variance

A one-way analysis of variance is conducted to examine if the ratings differ. The analysis suggested that the ratings for status differed significantly. Then, the intra correlation

coefficient (1) is measured, which represents the reliability of a single assessment of a group-level property (Bliese, 2000). The coefficient was .16. The Estimated reliability of the

individual director mean is measured by an intra correlation coefficient (2) (Bliese, 2000) The coefficient was .57. This suggests there was sufficient agreement about the status of the directors.

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4. Results

This chapter discusses the results of the various analyzes. First, the results of the correlation analysis are discussed. Then the results of the regression analysis relating to hypothesis 1 are described. Finally, the results of the regression analysis relating to hypothesis 2 are discussed. A correlation analysis is conducted to analyze the correlations between the variables. The results of the correlation analysis are shown in table 1. The correlation table shows that the correlation between earnings management and financial expertise of non-executives is -.15. However, this correlation is not significant (.22) as the two-tailed significance is above .05. Furthermore, a strong (.70) and significant (.00) relation is found between firm size and leverage.

The relationship between financial expertise of non-executives in the board of directors and the degree of earnings management has been analyzed by means of a regression analysis. Recall the regression formula, needed for the analysis:

= ∝₁+∝₂ 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙𝐸𝑥𝑝𝑒𝑟𝑡𝑖𝑠𝑒 +∝₃ 𝐹𝑖𝑟𝑚𝑆𝑖𝑧𝑒 +∝₄ 𝐹𝑖𝑟𝑚𝑃𝑒𝑟𝑓𝑜𝑟𝑚𝑎𝑛𝑐𝑒

+∝5 𝐵𝑜𝑎𝑟𝑑𝑀𝑒𝑒𝑡𝑖𝑛𝑔𝑠 +∝6 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 +∝7 𝐴𝑢𝑑𝑖𝑡𝐶𝑜𝑚𝑚𝑖𝑡𝑡𝑒𝑒 + 𝜀

The results of the regression analysis are shown in model 2 of table 2. There was a negative relationship between financial expertise of non-executives and earnings management, but it was not significant (Beta = -.13, p = .19). So hypothesis 1 cannot be accepted.

Another regression analysis is conducted to test the moderation effect of the social status of a CEO on the relationship between financial expertise of non-executives in the board and the degree of earnings management. Recall the regression formula, needed for the moderation analysis:

= ∝₁+∝₂ 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙𝐸𝑥𝑝𝑒𝑟𝑡𝑖𝑠𝑒 +∝₃ 𝑆𝑡𝑎𝑡𝑢𝑠𝐶𝐸𝑂 +∝₄ (𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙𝐸𝑥𝑝𝑒𝑟𝑡𝑖𝑠𝑒

∗ 𝑆𝑡𝑎𝑡𝑢𝑠𝐶𝐸𝑂) +∝5 𝐹𝑖𝑟𝑚𝑆𝑖𝑧𝑒 +∝6 𝐹𝑖𝑟𝑚𝑃𝑒𝑟𝑓𝑜𝑟𝑚𝑎𝑛𝑐𝑒

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Model 3 of table 2 shows the results of this regression analysis. The results show there is no significant interaction between the financial expertise of non-executives and social status of the CEO (Beta = -.41, p = .21). So hypothesis 2 cannot be accepted. This result differs from what was expected, because a negatively influence of the social status of the CEO on the relationship between a financial expert in the board of directors and the degree of earnings management was expected. However, these results show a not significant positive influence of the status of the CEO.

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Table 1: Correlations

Variables 1 2 3 4 5 6 7 8

1 Earnings Management -

2

Financial expertise

non-executives -0.15 - 3 Status CEO 0.14 -0.11 - 4 Leverage 0.02 0.10 -0.01 - 5 Firm performance -0.03 -0.05 0.13 0.10 - 6 Firm size -0.06 0.17* 0.12 0.70*** 0.16* - 7 Board meetings -0.09 -0.09 -0.21** 0.09 0.13 -0.08 - 8 Audit committee -0.05 0.28*** 0.05 0.03 -0.03 0.21** -0.08 - *p < 0.10, **p < 0.05 and ***p < 0.01

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Table 2: Regression Model 1 Model 2 Model 3

Step and variables Beta Beta Beta

Control Leverage 0.12 0.14 0.11 Firm performance -0.01 -0.03 -0.03 Firm size -0.13 -0.14 -0.12 Board meetings -0.10 -0.08 -0.09 Audit committee -0.04 0.00 0.02 Main effects

Financial expertise non-executives -0.13 -0.10

Status CEO 0.13 0.52

Two-way interaction

Financial expertise x Status CEO -0.41

R square 0.02 0.06 0.07

Δ R square 0.04 0.01

Note: this are standardized coefficients *p < 0.10, **p < 0.05 and ***p < 0.01

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5. Additional analysis

Prior research shows a relationship between a financial expert in the board of directors (Klein, 2002; Xie et al, 2003) and according to the SOX (2002), a financial expert in the board of directors is important to prevent fraudulent accounting. However, the results of the main analysis of this research are not significant (Beta = -.13, p = .19). In addition, a moderation effect of the status of the CEO was expected, but no significant results were found (Beta = -.41, p = .21). So some additional analyses are conducted to examine if there is a significant result if some adjustments are made in the sample or proxies.

5.1 Abnormal working capital accruals

An additional analysis is conducted to examine if the results differ when using another proxy for earnings management. DeFond & Park (2001) used the following formula as proxy for the abnormal accruals:

𝐴𝑊𝐶𝐴_𝑡= 𝑊𝐶_𝑡− [(𝑊𝐶𝑡−1

𝑆_𝑡−1 ) ∗ 𝑆𝑡]

Where AWCAt = abnormal working capital accruals in the current year, WCt = working

capital in the current year, WCt-1 = working capital of last year, St-1 = sales last year and S1 =

sales of the current year. The outcomes of the correlation analysis are shown in table 3 and the outcomes of the regression analysis are shown in table 4. One organization with discretionary accruals of -12.73 is Winsorized to -.03, because all the other organizations have discretionary accruals between -0.02 and 0.13. This means -12.73 is an extreme value. Assuming this observation is a correct observation, Winsorization is good method to modify the observation (Anscombe & Tukey, 1963).

The results of the regression analysis with abnormal working capital accruals as proxy differ from the results with the modified Jones model. Table 3 in appendix 1 shows a correlation between earnings management and financial expertise of non-executives of -.15. This

correlation is not significant (.11) as the two-tailed significance is above .10. Furthermore, the regression analysis shows a negative and significant relationship between the highest financial expertise of a non-executive in the board of directors and the degree of earnings management

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(Beta = -.17, p = .09), see model 2 of table 4 in appendix 1. So when using abnormal working capital accruals as proxy for earnings management, hypothesis 1 can be accepted.

The results show also there is no significant interaction between the financial expertise of non-executives and social status of the CEO (Beta = -.52, p = .11), see model 3 of table 4. A negative influence of the social status of the CEO on the relationship between a financial expert in the board of directors and the degree of earnings management was expected. This result shows a not significant negative influence whereby hypothesis 2 cannot be accepted again.

5.2 Organizations with audit committee

In addition, the effect of a non-executive financial expert on the degree of earnings

management within organizations with an audit committee is measured. The primary function of the audit committee is overseeing the financial process of the organization (Klein, 2006). According to Xie et al. (2003), the audit committee is a committee of the board of directors and has major influence on the board decisions. Furthermore, Klein (2002) found a negative relationship between audit committee independence and abnormal accruals. Therefore, a stronger relationship is expected for organizations with an audit committee.

The results of the correlation analysis are shown in table 5 and the results of the regression analysis in table 6 in appendix 2. Table 5 shows a not significant (.23) correlation of -.14 between a non-executive financial expert in the board and earnings management. Table 6 shows the relationships are a bit stronger than for the whole sample. For example, the relationship between financial expertise and earnings management is -.17 (table 6, model 2) instead of -.13 (table 2, model 2). However, the relationship is still not significant (p = .18). Also the moderation effect is not significant (Beta = -.53, p = .16).

The same analyses are conducted with abnormal working capital accrual as proxy for earnings management. The results of these analyses are shown in table 7 and table 8 in appendix 2. A not significant (.11) correlation of -.19 between a non-executive financial expert in the board and earnings management is founded, see table 7. Additionally, table 8 shows a significant negative relationship between a non-executive financial expert in the board and earnings management (Beta = -.24, p =.06), which corresponds with the results of the whole sample

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and using abnormal working capital accruals as proxy for earnings management. Furthermore, the moderation effect is negative again (-.60), but not significant (.12).

5.3 Higher status of the CEO than the financial expert

When the CEO has the highest rank in the informal hierarchy, the CEO has an enhanced capacity to pursue his/her own self-interests (He & Huang, 2011). Status is one of the most important bases of an informal hierarchy (Galinsky et al., 2008). So it would be expected that the moderation effect of status would be stronger when the CEO has a higher status than the board member with the most financial expertise. Therefore, an additional analysis has been conducted with a dummy variable for when the CEO has a higher status than the board member with the most financial expertise. The value of the dummy variable is 1 if the CEO has a higher status and 0 if the CEO does not have a higher status. The results are shown in table 9 and table 10 in appendix 3. There is no significant correlation between financial expertise and earnings management (p = .11), see table 9. Further, there is a negative relationship between a financial expert in the board of directors and the degree of earnings management, but this relationship is not significant (Beta = -.04, p = .74). Besides, there is a negative moderation effect, which is also not significant in this sample (Beta = -.18, p = .44). The same analysis has been done with abnormal working capital as proxy for earnings

management, see table 11 and 12 in appendix 3 for the results. The correlation between

earnings management and financial expertise was negative (-.15), but not significant (p = .11). Finally, table 12 shows a not significant and negative relationship between a financial expert in the board and the degree of earnings management (Beta = -.07, p = .52). The moderating effect is also not significant (Beta = -.07 p = .77).

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6. Conclusion and discussion

This chapter provides an answer to the research question of this research. Furthermore, the theoretical and practical implications are described. Finally, the limitations of this research are discussed.

6.1 Answer to the research question

The goal of this study was to gain insight in the board process concerning the effect of a non-executive financial expert in the board of directors to detect and counteract earnings

management. Hereby the influence of the social status of the CEO on the impact of the financial expert was examined. A negative impact of a financial expert in the board of directors on the degree of earnings management was expected. In addition, a negative

inlfuence of the social status of the CEO on the relationship between a financial expert in the board and the degree of earnings management was expected. However, initially no significant relationship has been found between financial expertise and the degree of earnings

management. On the other hand, when using abnormal working capital accruals as proxy for earnings management, a significant negative relationship between financial expertise and earnings management was found. A possible explanation for the difference in outcomes may be the omitting of the non-discretionary accruals by using abnormal working capital accruals and the addition of the change in total assets by the modified Jones model. The moderation effect is in no analysis significant, but there is still a trend in all analyzes that the social status of the CEO has a positive impact on the degree of earnings management. A possible

explanation for no significant moderation effect is the fact that only within 16 of the 117 organization of the sample the CEO has the highest status of all directors and only within 48 of the 117 organizations has the CEO a higher status than the financial expert in the board has.

The research question was: Does having a non-executive financial expert in the board reduce earnings management and how does the social status of the CEO affect this relationship? The answer to this question cannot be given by using the modified Jones model as proxy for earnings management, since no significant has been found for the relationship between

financial expertise in the board of directors and the degree of earnings management. Based on the additional analyses, still no answer can be given, because the additional analyses found no significant moderation effect.

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6.2 Theoretical implications

This study contributes to prior research by conducting a survey with board members to find out whether the board members have financial expertise. The survey also measured the height of the status of the CEO is in the eyes of the board members. Where the board process is treated as black box, because it is difficult for researchers to gain access to corporate boardrooms, this research did get access to the boards (Lelbanc & Schwartz, 2007). Many prior researches used working experience and education as proxy for financial experts and found a negative relationship between financial expertise in the board of directors and the degree of earnings management (Xie et al, 2003; Bédard et al., 2004; Carcello et al., 2006; Dhaliwal et al., 2006). In contrast to these studies, this study used self-rating questions as proxy for financial expertise, which corresponds better with the intra-personal construct of expertise (Bunderson, 2003), and found no significant evidence. This means that having a financial expert in the board not per se leads to a lower degree of earnings management. This possibly depends on the used proxy, because for this research another proxy is used for earnings management and unlike prior research, no significant relationship between a financial expert in the board of directors and earnings management is found. This means researchers must be aware of this when they draw a conclusion about financial experts. Another contribution of this research is the examining of the influence of the social status of the CEO on the degree of earnings management. The results are not consistent with the research of He & Huang (2011), which says that a higher status of the CEO may lead to more capacity to influence the other directors in the board and act more in his/her own interest. Acting in his/her own interest can be done by using earnings management, because earnings management may results in a higher compensation and better management performance, but it also may lead to negative effects for the organization (Graham et al., 2005; Healy & Wahlen, 1999). Since the moderation effect is not significant, it is not reflected in the results of this research that a CEO with a high status will influence directors to act in his/her own interest. So this research contributes to prior research by showing a high status of the CEO not lead to less functioning board of directors in the prevention of earnings management, while it was expected that the social status of the CEO leads to a less functioning board regarding earnings management.

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Furthermore, this research is consistent with the paper of Dechow & Skinner (2000), which says that earnings management is difficult to measure. There are several proxies to use for measuring earnings management by discretionary accruals (Dechow et al., 1995). Like the research of Leuz et al. (2003), which used four proxies for measuring earnings management, this research used multiple proxies. Earnings management is measured by the modified Jones model and by abnormal working capital accruals. The results are different from each other, since the use of abnormal working capital accruals as proxy leads to a significant relationship between a financial expert in the board of directors and the degree of earnings management and the use of the modified Jones model leads to no significant relationship. This shows that it is difficult to make some conclusions about earnings management.

6.3 Practical implications

Based on the results of main analysis, it can be concluded that adding a non-executive

financial expert to the board of directors, based on his/her own opinion, will not influence the degree of earnings management of the organization. Therefore, this does not have to be a criterion for the composition of the board of directors to lower the degree of earnings

management. Following the additional analysis it can be assumed that having a non-executive financial expert in the board of directors, based on self-report, will lead to lower abnormal working capital accruals. So an organization have to think about which kind of earnings management they want to counteract, because there is no clear definition of earnings management and this research shows different results with different measures of earnings management (Dechow & Skinner, 2000).

The results concerning the moderating effect of the status of the CEO are in no analysis significant. This means that an organization does not have to take into account the status of a CEO when they want to add a financial expert in the board of directors to prevent earnings management.

6.4 Limitations and directions for future research

As with every research, this study has also limitations. First, data is gathered from different years, because the surveys with the board of directors are taken at different times. So not for every organization the same financial year is used for the cross sectional variant of the modified Jones model. This does not exactly match with a cross sectional analysis, because a

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cross sectional analysis examines the different outcomes in the same period (Christie, 1987). Examining earnings management in the same financial year for all organization would ensure a more reliable result, because external factors may influence the degree of earnings

management.

Furthermore, as earlier mentioned, the specific setting of Dutch non-profit organizations is also a limitation. The degree of earnings management may vary per country (Leuz et al, 2003; Burghstahler et al, 2006). Of the 31 countries of the sample of Leuz et al (2003) has The Netherlands the 18th highest score. This means the results are not generalizable for other countries. In addition, the use of only non-profit organizations may be a limitation of this study. Nevertheless, Tan (2011) found managers of non-profit organizations also have incentives to engage in earnings management. If the organization makes a loss, the cost of debt may increase and when the organization has a high profit, it will lead to a greater level of scrutiny and they will face a greater pressure from the supervision of the government (Tan, 2011). So future research could investigate the relationship between a financial expert in the board of directors, measured by self-report, and earnings management in other countries and other industries.

Another limitation of this research is the low amount of organizations whereby the CEO has the highest status of all board members or a higher status than the board member with the most financial expertise. When the CEO has not the highest status, he/she has probably also not the highest rank in the informal hierarchy of the board members (He & Huang, 2001; Galinsky et al., 2008). Thereby the influence of the status of the CEO will be lesser on the degree of earnings management. A bigger total sample will probably solve this problem. Finally, the sample size is small compared to other studies of earnings management. The total sample consists of 117 organizations while Krishnan (2003) used a sample of 4422

organizations to examine the effect of auditor industry expertise on the level of earnings management. Also Cohen et al. (2008) used a much bigger sample size. Their sample consisted of 2018 organizations to examine the effect of the introduction of the SOX on earnings management. This means the used sample for this study is relatively small. A similar research with a bigger sample will give a more reliable result concerning earnings

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Appendix 1: Abnormal working capital accruals

Table 3: Correlations

Variables 1 2 3 4 5 6 7 8

2 Financial expertise non-executives -0.15 -

3 Status CEO -0.03 -0.11 - 4 Leverage -0.04 0.10 -0.01 - 5 Firm performance 0.04 -0.05 0.13 0.10 - 6 Firm size -0.11 0.17* 0.12 0.70*** 0.16* - 7 Board meetings -0.07 -0.09 -0.21** 0.09 0.13 0.08 - 8 Audit committee 0.02 0.28*** 0.05 0.03 -0.03 0.21** -0.08 - *p < 0.10, **p < 0.05 and ***p < 0.01

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Table 4: Regression Model 1 Model 2 Model 3

Control Leverage 0.09 0.08 0.05 Firm performance 0.07 0.07 0.08 Firm size -0.19 -0.15 -0.12 Board meetings -0.06 -0.09 -0.10 Audit committee 0.05 0.09 0.12 Main effects

Financial expertise

non-executives -0.17* -0.13

Status CEO -0.07 0.42

R square 0.02 0.05 0.07

Note: this are standardized coefficients *p < 0.10, **P < 0.05 and ***p < 0.01

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Appendix 2: Audit committee

Table 5: Correlations (MJM)

Variables 1 2 3 4 5 6 7

3 Status CEO 0.16 0.05 - 4 Leverage 0.05 0.25** -0.01 - 5 Firm performance -0.02 -0.01 0.00 0.04 - 6 Firm size -0.05 0.31*** 0.10 0.64*** 0.16 - 7 Board meetings -0.15 -0.05 -0.19** 0.12 0.12 0.19 - *p < 0.10, **p < 0.05 and ***p < 0.01

Table 6: Regression (MJM) Model 1 Model 2 Model 3

Control Leverage 0.15 0.18 0.13 Firm performance 0.01 0.00 0.00 Firm size -0.12 -0.11 -0.07 Board meetings -0.15 -0.13 -0.14 Main effects

Status CEO 0.15 0.65*

R square 0.04 0.08 0.11

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Table 7: Correlations (AWCA)

Variables 1 2 3 4 5 6 7

3 Status CEO -0.07 0.05 - 4 Leverage 0.06 0.25** -0.01 - 5 Firm performance 0.04 -0.01 0.00 0.04 - 6 Firm size 0.04 0.31*** 0.10 0.64*** 0.16 - 7 Board meetings -0.11 -0.05 -0.19** 0.12 0.12 0.19 - *p < 0.10, **p < 0.05 and ***p < 0.01

(39)

Table 8: Regression (AWCA) model 1 model 2 model 3

Control Leverage 0.07 0.07 0.17 Firm performance 0.05 0.04 0.04 Firm size 0.02 0.11 0.15 Board meetings -0.13 -0.18 -0.19 Main effects

Financial expertise

non-executives -0.24* -0.21*

Status CEO -0.11 0.45

R square 0.02 0.08 0.12

(40)

Appendix 3: Higher status of the CEO than the financial expert

Table 9: Correlations (MJM

Variables 1 2 3 4 5 6 7 8

3 Status CEO 0.09 -0.11 - 4 Leverage 0.02 0.10 -0.03 - 5 Firm performance -0.03 -0.05 -0.02 0.10 - 6 Firm size -0.06 0.17* 0.09 0.70*** 0.16* - 7 Board meetings -0.09 -0.09 -0.04 0.09 0.13 -0.08 - 8 Audit committee -0.05 0.28*** 0.04 0.03 -0.03 0.21** -0.08 - *p < 0.10, **p < 0.05 and ***p < 0.01

(41)

Table 10: Regression (MJM) Model 1 Model 2 Model 3

Control Leverage 0.12 0.13 0.12 Firm performance -0.01 -0.01 -0.01 Firm size -0.13 -0.15 -0.14 Board meetings -0.10 -0.09 -0.09 Audit committee -0.04 -0.04 -0.02 Main effects

Financial expertise non-executives 0.04 0.03

R square 0.02 0.03 0.04

(42)

Table 11: Correlations (AWCA)

Variables 1 2 3 4 5 6 7 8

3 Status CEO 0.05 -0.11 - 4 Leverage -0.04 0.10 -0.03 - 5 Firm performance 0.04 -0.05 -0.02 0.10 - 6 Firm size -0.11 0.17* 0.09 0.70*** 0.16* - 7 Board meetings -0.07 -0.09 -0.04 0.09 0.13 -0.08 - 8 Audit committee 0.02 0.28*** 0.04 0.03 -0.03 0.21** -0.08 - *p < 0.10, **p < 0.05 and ***p < 0.01

(43)

Table 12: Regression (AWCA) Model 1 Model 2 Model 3

Control Leverage 0.09 0.12 0.11 Firm performance 0.07 0.08 0.08 Firm size -0.19 -0.20 -0.20 Board meetings -0.06 -0.08 -0.08 Audit committee 0.05 0.06 0.07 Main effects

R square 0.02 0.03 0.03

Earnings management and the board process: the impact of the status of the CEO on the monitoring function of a financial expert in the board of directors.