Overlapping membership on audit and compensation committees, equity holdings, and financial reporting quality

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1 Overlapping membership on audit and compensation committees, equity holdings, and financial reporting quality Abstract: Purpose - This paper examines whether audit committee members of the board improve financial reporting quality if they are also on the compensation committee. This paper also examines audit committee member s equity holdings as a moderating variable. Background - Audit commit is responsible for overseeing financial reporting process of an organization and has been urged to broaden their understanding of business risk and incentives provided by the firms executive compensation structure. Acknowledging the interrelationship among executive compensation, risk taking and financial reporting quality, members of audit and compensation committee are advocating for more information sharing between the two committees. Although some prior studies have examined the governance implication of audit committee and compensation committee in isolation, there is paucity of research on the effect of overlapping committees for financial reporting quality. Design/Methodology/Approach We use a sample of Australian Stock Exchange listed companies, and discretionary accruals as a proxy for financial reporting quality, Findings - This study finds that firms with overlapping committees have better quality financial reporting than those without such overlap. This evidence is stronger in cases where managers tend to manage earnings upwards to meet or beat earnings benchmarks. Finally, audit committee equity holdings appear to have an adverse consequence on the beneficial effect of overlapping committees and financial reporting quality. Originality - We extend prior research on the association between overlapping committees and financial reporting quality by examining whether the presence of overlapping committees mitigates or exacerbates managerial propensity for meeting or beating earnings benchmarks. Practical implications - The findings reported here are expected to be useful for investors who consider different aspects of governance structure before making investment decisions. The findings also provide important policy implications to regulators regarding the audit committee equity holdings controversy. The finding also suggests a detrimental effect of equity holdings by directors with overlapping membership which might encourage regulators to consider restricting the practice of granting long-term incentive compensation to members of audit committees. Keywords: Audit committee, compensation committee, financial reporting quality, audit committee equity holdings 1

2 Overlapping membership on audit and compensation committees, equity holdings, and financial reporting quality 1. Introduction This paper examines empirically the association between financial reporting quality and overlapping membership on audit and compensation committees (overlapping committees), and explores the effect of equity holdings by directors with overlapping membership. Economic theory suggests that the board of directors is an important part of the governance structure of the corporation (Hermalin and Weisbach, 1998, 2003; Adams et al., 2010). Delegating different board functions to distinct committees represents a separation of tasks and functions, and has been strongly recommended as a suitable mechanism for improving corporate governance (Kesner, 1988; Spira and Bender, 2004). Adams and Ferreira (2007) show that if advising and monitoring functions are performed by the same group of directors, then the CEO is unwilling to share information that helps directors to provide advice, since the same information set can also be used for monitoring CEOs. A separation of functions is beneficial because it serves as a substitute for a commitment not to use the revealed information against the CEO (Laux and Laux, 2009). Two important sub-committees found in modern organizations are the audit and compensation committees. The audit committee is a subcommittee of the board of directors with delegated authority to oversee the auditing and financial reporting-related matters of the firm. The compensation committee, on the other hand, is entrusted with responsibility for setting managerial pay, which includes an optimal amount of performance-based incentive pay. 2

3 Understanding the costs and benefits of the board committee structure is important in order to evaluate the effectiveness of corporate governance mechanisms. Numerous publications have appeared in recent decades regarding the formation, effectiveness and corporate governance implications of audit committees. According to Bédard and Gendron (2010) the cumulative findings from an extensive body of audit committee literature finds some degree of association between audit committee characteristics (for instance, independence and financial accounting expertise) and some measures of effectiveness (for instance, financial reporting quality, cost of capital and audit fees). Notwithstanding the significance of audit committee characteristics for financial reporting quality, there are increasing calls for the broadening of audit committee members understanding of business strategies as being relevant for the oversight of financial reporting. Members of the accounting profession suggest that audit committees should have a broader understanding of business risks and incentives provided by firms executive compensation structures (KPMG, 2008). Acknowledging the interrelationships among executive compensation, risk taking and financial reporting quality, members of audit and compensation committees have been advocating more information-sharing between the two committees (Chandar et al. 2012). Although some prior studies have examined the governance implications of audit and compensation committees in isolation (e.g., Newman and Mozes, 1999; Anderson and Bizjak, 2003; Sun and Cahan, 2009) 1, 1 For reviews of the academic literature on audit committees, see DeZoort et al. (2002) and Bédard and Gendron (2010), among others. Regarding the association between composition of compensation committee and the design of executives pay, Newman and Mozes (1999) find that the relation between compensation and stock returns is significantly lower for firms whose compensation committee has at least one insider than for firms whose compensation committee has no insiders. Anderson and Bizjak (2003) find no evidence that the fraction of independent directors on the compensation committee results in a larger magnitude of payperformance sensitivity. Sun and Cahan (2009) construct a multidimensional measure of compensation committee quality and find that the positive association between CEO cash compensation and accounting earnings is stronger (weaker) for firms with high (low) compensation committee governance quality. Sun et al. (2009) find that future firm performance is more positively associated with stock option grants as compensation committee quality increases. 3

4 there is paucity of research on the effect of overlapping committees on financial reporting quality, and the available research provides mixed evidence. For example, Chandar et al. (2012) find that overlapping committees improve financial reporting quality but Liao and Hsu (2013) and Higgs (2003) suggest the opposite. We extend prior research on the association between overlapping committees and financial reporting quality by examining whether the presence of overlapping committees mitigates or exacerbates managerial propensity for meeting or beating earnings benchmarks. Extant research on benchmark-beating has found some evidence of deteriorating financial reporting quality for firms just beating some earnings benchmarks (Warfield and Cheng, 2005; Bauman et al. 2005). If overlapping committees are beneficial from a governance perspective, then the benchmark beating context should provide a powerful test, since CEOs have strong incentives for beating or meeting earnings thresholds through manipulative financial reporting to maximize short-run compensation at the expense of long-term shareholder value. We also extend the research on overlapping committees by investigating the moderating role of equity ownership by directors with overlapping membership on financial reporting quality. There is paucity of research on the consequences of equity holdings by overlapping audit committee members. Instead research has investigated the governance implications of audit committee members but the cumulative evidence is inconclusive. Bolton (2012) shows that audit committee stock ownership improves firm performance, whilst the detrimental effect of audit committee equity ownership from a financial reporting perspective is documented by Cullinan et al. (2010), Bedard et al. (2004), and Sharma and Kuang (2014). We use data from Australian stock exchange listed companies during the period 2001 to The Corporate Governance Principles and Recommendations developed by Australian 4

5 Stock Exchange (ASX) Corporate Governance include the characteristics of corporate boards recommended for ASX listed companies. Principle 2 of the code: Structure the Board to add Value, recommends that a company should establish an audit committee that consists of at least three members, all of whom are non-executive directors and a majority of whom are independent directors, and chaired by an independent director who is not the chair of the board. New recommendations on the composition of the remuneration committee were added in Principle 8 recommends the establishment of a remuneration committee that should have at least three members, the majority of whom are independent, and is chaired by an independent director. Although the Corporate Governance Principles recommend separate audit and remuneration committees, no recommendation is made regarding overlapping committees. Our empirical analysis reveals that financial reporting quality (proxied by discretionary accruals) is better for firms where at least one audit committee member also sits on the compensation committee. We also find that this beneficial effect is more pronounced for firms who tend to meet or beat earnings benchmarks. Finally, we reveal that financial reporting quality is lower in firms with overlapping directors who own equity in the company compared to firms where overlapping directors don t own equity. The findings reported here are expected to be useful for investors who consider different aspects of governance structure before making investment decisions. One such governance practice where at least one audit committee member is also on the compensation committee appears to improve financial reporting quality. The findings also provide important policy implications to regulators regarding the audit committee equity holdings controversy. The finding reported here suggests a detrimental effect of equity holdings by directors with 5

6 overlapping membership which might encourage regulators to consider restricting the practice of granting long-term incentive compensation to members of audit committees. The remainder of the paper proceeds as follows: Section 2 reviews the related literature and develops testable hypotheses; Section 3 explains the research design choices and sample selection procedure; the following section provides descriptive statistics and correlation analyses; Section 5 presents the results of the hypotheses; and a final section concludes the paper. 2. Literature review and hypotheses development The corporate board is the cornerstone of a firm s governance system. The establishment of board committees has been strongly recommended as a suitable mechanism for improving corporate governance by delegating specific tasks from the main board to a smaller group (Kesner, 1988; Spira and Bender, 2004). Because boards have multiple committees and a limited number of directors, board members often serve on more than one board committee. Two common board committees on which directors serve are the audit committee and the compensation committee. Audit committees oversee the audit scope and the adequacy of the independent public accountant s audit plans and results, review and monitor the annual and quarterly financial statements and other financial reports, and monitor the internal accounting controls. Audit committee independence and audit committee financial expertise are the two most important characteristics assumed to help audit committee members discharge their responsibilities. Research has tried to ascertain the impact of different proportions of audit committee independence on financial reporting quality, but the results have been very mixed. Davidson et al. (2005), Klein (2002), and Ghosh et al. (2010) find no association between audit committee 6

7 independence and earnings management, but Bédard et al. (2004) report that fully independent audit committee members constrain aggressive earnings management. A recent study by Bronson et al. (2009) provides indirect evidence of the benefit of having an independent audit committee by documenting that such a committee may help ensure that an audit firm issues a going-concern opinion to financially distressed firms. Research on audit committee financial expertise has found that having more financial experts on the audit committee increases earnings quality (Abbott et al., 2003; Bédard et al., 2004; Krishnan and Visvanathan, 2008; Dhaliwal et al., 2010), reduces the probability of restatements (Marciukaityte and Varma, 2008; Abbott et al., 2004; Cohen et al., 2010) and increases the probability of more timely remediation of internal control weaknesses (Goh, 2009). This stream of research has examined the role of the audit committee as a separate subcommittee of the board. However, as board members often serve on multiple committees within a firm, it is likely that there will be committee overlaps. A potential advantage of delegating board functions to committees is that using smaller subgroups can reduce the free-rider problem that plagues larger groups (Laux and Laux, 2009). Since effective information processing depends on the availability of sufficient information and knowledge (Nowak and McCabe, 2003), overlapping allows a director to acquire knowledge that can facilitate coordination between the compensation and audit committees (Hermanson et al., 2012; Moody s Investors Service, 2006). It is therefore plausible that audit committee members who are also on the compensation committee should have more direct knowledge of the managements compensation-related incentives in making certain accounting choices. Since incentive-based compensation encourages managers to engage in accounting manipulation to maximise their personal wealth, coordination between audit and compensation committees should allow the 7

8 former to be an effective monitor. 2 Unless audit committee members have a thorough understanding of compensation committee objectives, they cannot take monitoring actions consistent with managers reporting incentives (Liao and Hsu, 2013). However, overlapping committees can lower the effectiveness of independent directors, because directors with common membership can become overcommitted and, thus, might shirk their responsibilities as monitors (Ferris et al., 2003; Laux and Laux, 2009). In addition, the overlapping of committees might encourage compensation committees to reduce the audit committee s monitoring responsibilities by designing low incentive-based compensation (e.g., Laux and Laux, 2009). Notwithstanding the downside of overlapping committees, we believe the information sharing and knowledge spillover benefits emanating from overlapping committees would outweigh the costs associated with having overlapping committees. Based on this, we develop the following hypothesis in alternate form: H 1 : Ceteris paribus, firms with an overlap of audit and compensation committees will have better quality financial reporting than a firm without overlapping committees. The hypothesis above, however, does not consider any specific context where overlapping committees might prove to be more useful. We consider managerial propensity to achieve earnings thresholds as one such context. Accounting earnings are viewed as the premier information item provided in financial statements and widely used as a key performance indicator of business success (Lev 1989; Graham et al., 2005). A comprehensive survey of Chief 2 Although the incentive compensation scheme for executives should align manager and shareholder interests (Jensen and Meckling, 1976), managers have been found to be guilty of managing earnings to maximize their compensation. For example, Bartov and Mohanram (2004) find evidence of earnings management leading up to option exercises. Cheng and Warfield (2005) find that stock option exercises and holdings provide incentives for firms to meet or beat earnings targets. Bergstresser et al. (2006) find that firms make more aggressive assumptions in their defined benefit pension plans in the period in which they exercise their options. 8

9 Financial Officers (CFO) by Graham et al. (2005) show the GAAP earnings number, especially the earnings per share (EPS), is the key metric upon which the market focuses. Managers are, therefore, concerned about reporting an earnings number that meets or exceeds market expectations. This behavior is consistent with Kahneman and Tversky s (1979) prospect theory which postulates that losses are more displeasing than the equivalent gain. This feature of prospect theory, therefore, suggests that, ceteris paribus, investors will prefer to invest in companies that report a series of small gains rather than companies with volatile earnings (Koonce and Mercer, 2005, p. 191). Given the significant potential benefits associated with meeting or beating earnings benchmarks, managers are not passive in the earnings game. Rather they actively try to win the game by altering reported earnings and/or influencing analysts expectations. 3 Thus managerial propensity to manage earnings to meet or beat earnings threshold has caused concern for regulators and investors. One of the most important incentives for meeting earnings targets relate to CEO compensation. Warfield and Cheng (2005) show that firms with high equity incentives are more likely to meet or just beat analysts forecasts. Bauman et al. (2005) find that firms compensating top managers more heavily with stock options employ income-increasing abnormal accruals to enable them to more frequently meet analysts earnings targets. Matsunaga and Park (2001) find CEO bonus payments give CEOs an economic incentive to beat the analyst forecast benchmark and the earnings changes benchmark. Directors with overlapping membership have the distinct advantage of understanding the earnings management incentives emanating from executive 3 Prior research on benchmark-beating has found some evidence of market premiums for firms that are able to meet or beat earnings thresholds (avoiding losses, reporting positive earnings changes, and meeting or beating analyst s forecasts). Kasznik and McNichols (2002) find that firms that meet or beat analysts forecasts in the current and preceding two years command a market premium. Brown and Caylor (2005) find that firms meeting or beating at least one or any combination of the three benchmarks have a positive valuation consequence, as compared to firms that meet none of the three benchmarks. 9

10 compensation structure because of their common membership in audit and compensation committees. Since equity incentives encourage managers to manipulate accounting information, we argue that if common membership offers better oversight, then it should be more pronounced in cases where managers tend to meet or beat earnings thresholds. The following hypothesis is therefore developed: H 2 : Ceteris paribus, an overlap of audit committee and compensation committee members of the board constrains earnings management for benchmark beating firms. Finally we examine the association between long-term incentive compensation for overlapping directors (at least one audit committee members with equity holdings also sits on the compensation committee) and financial reporting quality. The ASX corporate governance principles and recommendations state that it is generally acceptable for non-executive directors to receive securities as part of their remuneration, to align their interests with the interests of other security holders. However, non-executive directors generally should not receive options with performance hurdles attached or performance rights as part of their remuneration as it may lead to bias in their decision-making and compromise their objectivity (p. 33). However, from an agency theory view compensating directors with long-term incentive-based pay is premised on the observation that directors assume the critical job of monitoring management on behalf of shareholders (Hillman and Dalziel 2003; Jensen and Meckling, 1976). Directors act as monitors with incentives to watch managers for opportunistic, self-interested behavior that increases the managers personal wealth while decreasing firm value (Watts and Zimmerman, 1986). For audit committees, the potential to reduce agency costs is related to monitoring of financial reporting quality. Compensating audit committee members with overlapping 10

11 directorship with long-term equity-based incentive compensation should strengthen their focus on long-term interests of shareholders (Hillman and Dalziel 2003). Conversely, denying them access to long-term equity appreciation can undermine their incentive to monitor management actively and prioritize owners interests (Dalton et al., 2003; Archambeault et al., 2008). There is paucity of research on the consequences of equity holdings by overlapping audit committee members. Instead research has investigated the governance implications of audit committee members but provides conflicting evidence. On the one hand, some research offers evidence favoring increased equity holdings by audit committee members. MacGregor (2012) finds that equity holdings increase audit committee responsiveness to risk. Vafeas (2005) finds that audit committee share ownership enhances earnings quality, and Beasley et al. (2000) reveal that an increased level of ownership held by audit committee members reduces financial statement fraud. Bolton (2014) also finds that audit committee shareholding is related positively to firm performance, and suggests that a high dollar value of stock owned by members of a firm s audit committee can be an effective mechanism for aligning the interests of directors and external shareholders. On the other hand, compensating audit committee directors with stock options and shareholding may diminish the objectivity of such audit committee directors (Magilke et al., 2009; Yang and Krishnan, 2005). The latter study reveals that stock ownership by audit committee members increases quarterly earnings management. Cullinan et al. (2010) reveal that firms with a stock option plan for their audit committee members are significantly more likely to report an internal control weakness than firms without such a compensation plan. Archambeault et al. (2008) find that audit committee incentive-based compensation is positively associated with financial restatements. Bedard et al. (2004) find a positive association between audit 11

12 committee member-stock options and aggressive earnings management behavior. Using the New Zealand corporate governance setting, Sharma and Kuang (2014) evidence that greater stock ownership by non-executive and executive directors serving on the audit committee increases the risk of aggressive earnings management. The effect of equity holdings by directors with overlapping memberships compared to directors with overlapping memberships without equity holdings could have two opposing effects on financial reporting quality. On one hand, equity holdings by directors with overlapping memberships could align their interests with shareholders which provide more effective oversight for constraining managerial opportunistic actions for maximizing executive compensation. On the other hand, an entrenchment perspective is equally appealing whereby overlapping directors with equity holdings could support managerial opportunistic accounting policy choices for short term wealth maximization, as this would also benefit audit overlapping directors with equity holdings. Given the competing arguments postulated here, we develop the following hypothesis: H 3 : There is an association between financial reporting quality and equity holdings by directors with overlapping memberships. 3. Research design 3.1 Sample identification Our sample selection process starts with an initial sample of 13,752 firm-year observations having sufficient data available for calculating discretionary accruals for the period , retrieved from the Aspect Financial database. In keeping with earnings management research, we 12

13 exclude financial services firms owing to fundamental differences in their accrual generating process. We retrieve data on common membership and other governance variables from SIRCA Corporate Governance Database. This database covers governance data for 1500 listed Australian firms. Therefore the data used for examining the effect of committee overlap on financial reporting quality is significantly smaller than the discretionary accruals data. Our final sample consists of 6,791 firm-year observations with common membership data from Our sample is further reduced to 3,455 firm-year observations for the analysis of audit committee equity holdings by overlapping directors and financial reporting quality (equation 3). Panel A of Table 1 details the sample selection procedure. [TABLE 1 ABOUT HERE] Panel B of Table 1 presents industry distribution of the sample observations. Twenty eight percent of the sample observations come from the Materials industry, followed by the Energy and Capital goods sectors (11% and 9% respectively). Because of the variation in industry distribution of the sample observations, all our regression specifications include industry fixed effects. 3.2 Earnings management measure Our proxy for financial reporting quality is discretionary accruals (Jones, 1991). Kothari et al. (2005) develop a performance-matched discretionary accruals model designed to alleviate the mis-specification problem when applied to samples experiencing non-random performance. We estimate the following equation for all firms in the same industry with at least 8 observations in 13

14 each year (using the SIC two-digit industry code) to get industry-specific parameters for calculating the non-discretionary component of total accruals (NDA). ACC t 0( 1/ Assets t 1) 1 Sales t RECEIVABLEt 2PPEt 3ROAt 1 t...( 1) We measure total accruals (ACC) as the difference between net income after tax (NPAT) and operating cash flows (OCF) following Collins and Hribar (2002). where ΔSALES is the change in sales from year t-1 to year t, ΔRECEIVABLE is the change in accounts receivable from year t-1 to year t, PPE is gross property, plant and equipment, and ROA is return on assets. Lagged ROA is included in the model following Kothari et al. (2005) to control for extreme performance. All variables are deflated by lagged total assets to control for heteroscedasticity. Discretionary accruals (DAC) is then the residual from equation (1), i.e. DAC=ACC-NDAC. Because both earnings overstatements and understatements are an indication of earnings management, we use the absolute value of discretionary accruals in line with prior literature (Klein, 2002; Zhao and Chen, 2008). However, we acknowledge that underestimation of earnings due to negative discretionary accruals is a special form of conservatism, which may be an indication of better quality financial reporting. We, therefore, run the regressions for both income-increasing and income-decreasing abnormal accruals sub-samples Overlapping committee and financial reporting quality To assess the effect of overlapping committee on financial reporting quality (test of H 1 ) we estimate the following regression model ABSDAC 0 1OVLAP 2SIZE 3LEVERAGE 4LOSS 5OCF 6GROWTH 7BIG4 CEODUAL INDPEN BSIZE...(2) i, t 14

15 Our variable of primary interest is OVLAP, an indicator variable coded 1 if at least one audit committee member is on the compensation committee and zero otherwise. If committee overlap is beneficial from a governance perspective, then we should expect a negative and significant coefficient on β 1. We also include a set of control variables commonly used in earnings management literature. SIZE is the natural log of total assets and is expected to be negatively associated with discretionary accruals because larger firms have more sophisticated internal control systems and are audited by high quality auditors. LEVERAGE is firm leverage measured as the ratio of the sum of the short term and long-term debt over total assets and is expected to be associated with discretionary accruals positively, as DeFond and Jiambalvo (1994) find that firms manage earnings prior to the debt covenant violations. LOSS is an indicator variable coded 1 for firm-year observations with negative earnings and is likely to increase discretionary accruals. OCF is operating cash flows divided by total assets and is expected to be associated with discretionary accruals negatively, because of the mechanical negative relationship between accruals and OCF (Subramanyam, 1996). GROWTH is change in sales over total assets and is expected to be associated with discretionary accruals positively (Menon and Williams, 2004). BIG4 is a dummy variable coded 1 for firm-year observations audited by Big4 audit firms and zero otherwise. We expect a negative coefficient following the argument that high quality auditors constrain earnings management (Becker et al., 1998). We also include a set of governance variables likely to affect discretionary accruals. CEODUAL is an indicator variable coded 1 for firm-year observations with the CEO also serving as chairman of the board, and is expected to be related to discretionary accruals positively. INDPEN is the proportion of independent directors to total number of directors and should be related to discretionary accruals negatively because of better monitoring by independent directors (Klein, 15

16 2002). Finally BSIZE is the natural log of the number of directors on the board, and could have either a negative or positive association with abnormal accruals. To take into account the time series and cross-sectional dependence in the error terms of our regressions, we calculate t- statistics using standard errors that are clustered by both firm and year (Peterson, 2009). To test whether the association between committee overlap and financial reporting quality is moderated by benchmark beating incentives, we estimate the following regression equation: DAC 0 1OVLAP 2J _ BEAT 3J _ BEAT* OVLAP 4SIZE 5LEVERAGE 6LOSS OCF GROWTH BIG4 CEODUAL INDPEN BSIZE...(3) We use signed instead of absolute DAC for this analysis because of a stronger theoretical prediction for income-increasing earnings management for firms meeting or beating benchmarks. J_BEAT is an indicator variable coded 1 if the firm reports small earnings levels, or earnings changes between 0 and 2 per cent of lagged total assets, and 0 otherwise. Other variables are defined as before. If overlapping membership helps constrain opportunistic earnings management behavior to achieve earnings thresholds then we should expect a negative and significant coefficient on κ 3. Finally, to test for the effect of equity holdings by overlapping directors on financial reporting quality (test of H 3 ), we estimate the following regression equation i, t ABSDAC 0 1HOLD 2SIZE 3LEVERAGE 4LOSS 5OCF 6GROWTH BIG CEODUAL INDPEN BSIZE...(4) i, t Regression equation (4) is estimated for the restricted sample of overlapping directors with equity holdings to assess the relationship between financial reporting quality and overlapping memberships for two mutually exclusive group of firms (one where directors with 16

17 overlapping memberships own equity and the other where directors with overlapping memberships don t own equity). This distinction is captured by the dummy variable HOLD taking the value of 1 for overlapping directors with equity holdings and zero otherwise. Equity holdings are measured in terms of dollar values of incentives compensation. SIRCA database provides information on equity-based compensation for executives and independent directors. We collected data on options granted, fair value of the option and exercise price for directors with overlapping membership to determine the total amount of option-based compensation. Consistent with Archambeault et al. (2008), we value stock options at 25 percent of their exercise price when fair value is not available. Due to data limitations we were unable to distinguish long-term versus short-term options. Given the competing arguments regarding the corporate governance implications of audit committee members equity holdings, we don t predict the sign and significance on the indicator variable, α Descriptive statistics Table 2 Panel A presents descriptive statistics. ABSDAC is 10% of lagged total assets whilst income increasing and income decreasing DAC are 9% and -10% of lagged total assets respectively with an average DAC very close to zero by construction. Fifty six percent of firmyear observations have at least one audit committee member who is also on the compensation committee. There is almost a monotonic increase in the percentage of OVLAP with a low of 43% in 2001 to 64% in Audit committee members, on average, have an equity ownership of 32% but this varies significantly among companies (a standard deviation of 0.35). Sample firms are moderately leveraged (debt ratio is 20% of total assets). About 43% of the firm-year observations report negative earnings. Sample firms also report negative OCF (average of -5% of 17

18 total assets). About 64% of the firm-year observations are audited by one of the Big4 audit firms. Growth opportunity, measured as sales growth, is highly skewed and a very high standard deviation caused by some extreme observations remains even after winsorization. A high proportion of firm-year observations have both CEO and board chairman being the same person. Panel B reports the correlation analysis. The correlation between OVLAP and ABSDAC is significantly negative confirming that overlapping committees constrain earnings management. OVLAP is significantly and positively correlated with firm size, BIG4 audit, CEODUAL and BSIZE whilst being significantly and negatively correlated with the proportion of negative earnings. None of the pairwise correlations among the independent variables exceeds 0.7 (the highest reported correlation is 0.69 between SIZE and BDSIZE), suggesting that there are no multicollinearity concerns. We also conducted variance inflation factor (VIF) tests to check for any multicollinearity and find no concern for multicollinearity as none of the VIF exceeds an acceptable limit of [TABLE 2 ABOUT HERE] Table 3 reports univariate analysis of the difference in means of the independent variables for firm-year observations with and without overlapping committees. Average ABSDAC is 0.08 for firm-year observations with overlapping committees which is significantly smaller than their non-overlapping committee counterparts (an average ABSDAC of 0.12). Both income-increasing and income-decreasing discretionary accruals are significantly smaller for the former group. Firms with overlapping committees are larger, have higher operating cash flows, incur less negative earnings but have less growth potential. About 91% of the firm-year observations with overlapping committees is characterised by a CEO also acting as chair of the 18

19 board, which is significantly higher than the firm-year observations without overlapping committees. [TABLE 3 ABOUT HERE] 5. Main test results Table 4 presents the regression result for equation (2) which examines the effect of committee overlap on financial reporting quality. We regress ABSDAC, the proxy for financial reporting quality, on the indicator variable OVLAP and a set of control variables known to affect reported DAC. In keeping with prior literature, firms with large absolute DAC are assumed to have lower financial reporting quality compared to firms with smaller discretionary accruals (Klein, 2002; Zhao and Chen, 2008; Chandar et al., 2012). [TABLE 4 ABOUT HERE] The regression result for equation (2) reveals a negative and significant coefficient on OVLAP suggesting that firms with overlapping committees, where at least one audit committee member is also on the compensation committee, have on average, lower levels of discretionary accruals than firms without such overlap. The coefficient implies that discretionary accruals as a percentage of lagged total assets are about 1% lower for the former group. Among the control variables, firm size is found to be negatively related to ABSDAC whilst firm leverage and firm growth opportunities reveal a positive relationship. These findings are consistent with extant research that finds better quality reporting by larger firms but a tendency for earnings manipulation by highly-leveraged firms to avoid covenant violation. Empirical evidence on the association between growth opportunities and earnings manipulation is not conclusive as firms 19

20 with higher growth opportunities could use reporting discretion to signal value-relevant information. For income-increasing and income-decreasing sub-samples, we find that although the coefficient on OVLAP is negative as predicted, it is insignificant (p-value 0.14) for the income-increasing sub-sample. This may be attributed to the absence of any particular context where the existence of overlapping committees may be more beneficial in constraining incomeincreasing earnings management practices. The coefficient on OVLAP is positive and significant for the income-decreasing sub-sample, suggesting that overlapping committees help constrain income-decreasing earnings management. Taken together, our first set of analyses provides support for H 1. Our second set of analyses examines the effect of overlapping committees on managerial propensity to meet or beat earnings thresholds. A large volume of research has found evidence of a managerial tendency to manage earnings for meeting or beating earnings benchmarks because of the market premium associated with achieving benchmarks (for a review of this strand of literature see Habib and Hansen, 2008). We test two earnings benchmarks, namely loss avoidance, proxied by J_BEAT, an indicator variable coded 1 if net income scaled by lagged total assets is within the range 0-2%, and zero otherwise, and small increase in earnings, where J_BEAT is coded 1 if the change in net income scaled by lagged total assets falls within the range 0-2%, and zero otherwise. The regression results of equation (3) are presented in Table 5. [TABLE 5 ABOUT HERE] The coefficient on J_BEAT is positive and significant for both the earnings benchmark levels implying that managers engage in income-increasing earnings management to meet earnings benchmarks (signed DAC is used for this regression analysis). However, the interactive 20

21 coefficient J_BEAT*OVLAP is negative and statistically significant for both loss avoidance and small increase in earnings threshold sample (the coefficients are and respectively). This evidence supports a beneficial role of overlapping committees in that firm-year observations with overlapping committees constrain income-increasing earnings management aimed towards meeting or beating earnings benchmarks, and hence supports H 2. An f-test on the null hypothesis of OVLAP*J_BEAT to be zero is rejected at the 1% level (f-statistic, 4.14, p-value 0.01) which provides support for the incremental impact of overlapping audit committees in constraining income-increasing earnings management for the loss avoidance sample. For the small earnings change analysis, however, the f-statistic is insignificant. 4 Our final set of analyses examines whether equity holdings by directors with overlapping memberships affect financial reporting quality (test of H 3 ). Table 6 presents the regression results for equation (4). The coefficient on the dummy variable HOLD is positive and significant (coefficient 0.01, t-statistics 2.39). The positive and significant coefficient suggests that equity holdings by directors with common membership adversely affect financial reporting quality. A plausible explanation for this finding could be attributed to the fact that overlapping audit committee members with equity holdings could support questionable accounting policy choices by managers in order to manipulate earnings for short term wealth maximization. This finding raises doubt about audit committee members with equity holdings who are also on the compensation committee. The findings reported here add to the literature on the rationale for 4 We conducted a pseudo-target analysis whereby we ran the same regression model for net income interval 2%-4%, 4%-6%, 6%-8%, and 8%-10% range. We found the interactive coefficient J_BEAT*OVLAP to be negative but insignificant for the 4%-6% target; negative and marginally significant for 6%-8% range (coefficient , t- statistics -1.74); negative but insignificant for the 6%-8% target; and finally significantly negative for the 8%-10% target. 21

22 audit committee members equity holdings, and provide policy implications for strengthening audit committee independence. Sensitivity tests: [TABLE 6 ABOUT HERE] (i) CEO compensation, overlapping membership and financial reporting quality: In their analytical model, Laux and Laux (2009) propose that an increase in stock-based CEO compensation is not necessarily associated with an increase in the level of earnings management. On one hand, a powerful incentive package increases the CEO s direct incentive to engage in manipulation, but, on the other hand, it also increases the audit committee s oversight function, which in turn prevents and deters manipulation. Depending on which effect is stronger, the magnitude of earnings management can increase or decrease with CEO compensation. We, therefore, run a sensitivity test by including natural log of lagged total compensation (both short and long-term compensation) in the regression of absolute DAC on overlapping committee dummy. Untabulated result reveals that the coefficient on compensation is positive and significant (coefficient , t-statistic 1.82). Coefficient on OVLAP remains negative and statistically significant (coefficient -0.01, t-statistic -3.00). (ii) Change analysis: The regression results presented thus far have assumed a contemporaneous association between committee overlap and financial reporting quality. However, it can be argued that the effect of overlapping committees may become stronger in subsequent years because of the learning effect, and also because of the fact that overlapping committees could be formed any time during the year. We, therefore, consider changes in ABSDAC in t+1 as the dependent variable, and 22

23 overlapping committees in period t as the primary independent variable. Untabulated results reveal a negative and significant coefficient on OVLAP (coefficient , t-statistic 1.89, significant at better than the 10% level) after controlling for changes in the control variables. (iii) Overlapping directors with accounting expertise and financial reporting quality: We also considered the effects of audit committee accounting expertise who are also overlapping members on financial reporting quality. It is believed that having more financial experts on the audit committee increases earnings quality (Abbott et al., 2003; Bédard et al., 2004; Baxter and Cotter, 2009; Krishnan and Visvanathan, 2008), reduces the probability of restatements (Abbott et al., 2004) and increases the probability of more timely remediation of internal control weaknesses (Goh, 2009). Dhaliwal et al. (2010) find that audit committee accounting expertise is positively associated with financial reporting quality as proxies by accruals quality. We created an indicator variable coded 1 if at least one accounting expert serves on both the audit and compensation committee and 0 otherwise in an attempt to segregate the effect of accounting experts who are overlapping members, on financial reporting quality. Untabulated result shows the coefficient on this dummy variable to be negative and significant at better than the 5% level (coefficient , t-statistics -2.11). This evidence suggests that accounting experts who are also overlapping members provide more effective oversight of opportunistic accounting policy choices. The results presented above are subject to a number of limitations. First, the sample is restricted to top 1,500 Australian Stock Exchange listed companies on the basis of market capitalization. The reported findings, therefore, can t be generalized to the population of listed companies. Second, although we have attempted to account for endogenous relationship between overlapping committees and financial reporting quality by considering the effect of lagged 23

24 overlapping committees on current-period discretionary accruals, the endogeneioty concern may still remain. 6. Concluding remarks In this paper we have examined the effect of overlapping committees on financial reporting quality, and the moderating role of audit committee equity holdings. One of the desirable properties of good corporate governance is to establish a board that has the expertise to monitor and provide advisory services to management. To achieve these goals, boards function through different sub-committees. Two of the important board sub-committees are the audit committee, entrusted with the responsibility of overseeing financial reporting process, and the compensation committee, responsible for executive compensation arrangements. There have recently been calls for audit committee members to have a broader understanding of the business risks and incentives provided by their firms executive compensation structure (KPMG, 2008). Acknowledging the interrelationship among executive compensation, risk taking and financial reporting quality, members of audit and compensation committees are advocating more information-sharing between the two committees. Using data from the Australian stock exchange listed companies we document three important findings. First, the existence of overlapping committees improves financial reporting quality. Second, this beneficial effect of overlapping committees is more pronounced when the managerial propensity to meet or beat earnings benchmarks is taken into account. It is found that although managers engage in income-increasing earnings management to meet benchmarks, overlapping committees constrain such behavior. Finally, we examine the effect of equity 24

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