The Effect of Distracted Audit Committee Members on Earnings Quality

Transcription

1 The Effect of Distracted Audit Committee Members on Earnings Quality Susan Elkinawy Loyola Marymount University Department of Finance and Computer Information Systems Hilton Center for Business One LMU Drive, MS 8385 Los Angeles, CA Phone: Joshua Spizman Loyola Marymount University Department of Finance and Computer Information Systems Hilton Center for Business One LMU Drive, MS 8385 Los Angeles, CA Phone: Hai Tran Loyola Marymount University Department of Finance and Computer Information Systems Hilton Center for Business One LMU Drive, MS 8385 Los Angeles, CA Phone: January 2018

2 The Effect of Distracted Audit Committee Members on Earnings Quality Abstract In this paper, we examine how audit committee attention impacts the earnings quality of firms whose boards they serve on. Specifically, we study how major events at firms a director serves on affects their ability to monitor other boards in which they serve as an audit committee member. The reduction in time they can spend monitoring leads to lower earnings quality. We first show that distracted audit committee members are more likely to miss board meetings at their non-event firms. This evidence shows that distracted directors miss more meetings due to an increased time commitment at the event firms, not due to changes at the non-event firms. We next show that earnings quality declines at firms with distracted audit committee members in the year of the distracting event. Our results contribute to the literature on busy boards and earnings quality as well as contribute to policy debates surrounding board of director composition. Keywords: busy directors; director attention; corporate governance; earnings quality JEL Codes: G30, G34

3 1 Introduction Whether shareholders benefit from owning firms whose directors sit on multiple boards of directors is an ongoing debate. Fama (1980) suggests that directors who hold multiple board seats benefit shareholders because they are better qualified and, therefore, highly sought after. A recent Wall Street Journal article implies that major institutional shareholders are concerned about overboarding and have actively voted against the re-election of board members due to the perceived inability of these directors to adequately monitor management. Supporting this concern, Institutional Shareholder Services lowered the recommended number of outside board seats from six to five in February These developments suggest that the cost of insufficient monitoring is perceived to be greater than the experience these directors gain from holding multiple board seats. The evidence is mixed regarding the relationship between busy directors (defined as holding three or more board seats) and monitoring effectiveness. Beasley (1996) and Fich and Shivdasani (2006) find that directors with multiple board seats lead to inefficient monitoring and subsequent unfavorable firm outcomes due to additional demands on their schedules. Pritchard, Ferris, and Jagannathan (2003) do not find evidence that multiple directorships lead to inadequate monitoring. Sharma and Iselin (2012) find a positive association between financial misstatements and busy audit committee members, but only in the post-sox period. However, audit committee members who are financial experts do not shirk their responsibilities. Tanyi and Smith (2015) show that audit committee busyness only affects the financial reporting quality if the audit committee chair and/or financial experts are busy. 1 Krouse, Sarah and Joann S. Lublin, Big Investors Want Directors to Stop Sitting On So Many Boards, Wall Street Journal. September 26,

4 A challenge in the prior literature on director busyness is that the number of directorships could simultaneously represent over-commitment and director quality. 2 A growing line of literature attempts to address this issue by studying a shock to director busyness. Masulis and Zhang (2017) find that directors who experience a major event attend fewer board meetings, are more likely to give up board seats, and experience a decline in firm value. Stein and Zhao (2016) find that independent directors who experience poor performance at the firm where they are employed are more likely to miss board meetings. These firms have poor performance and worse governance. Hauser (JFE, forthcoming) finds that when busy directors experience a reduction in board seats from a merger, the firms they continue with experience subsequently higher operating earnings and market value due to a reduction in workload. In this paper, we examine major distracting events that create a shock to director busyness, while focusing on the shocks impact on members of the audit committee. First, the passage of SOX imposes significant additional reporting responsibilities on the firm, increasing the workload of directors and the audit committee in particular (Linck, Netter, and Yang (2008) and Ward (2009)). As a result, distractions may have more adverse effects on audit committee members than they do other directors on the board. Second, the audit committee plays an important oversight role in monitoring management. Due to distractions at other firms, audit committee members ability to monitor effectively may be compromised, leading to negative consequences for the firm and shareholders. We attempt to answer two research questions in this study. First, does a shock to the busyness (henceforth referred to as a distraction ) of audit committee members cause them to 2 In addition to having to split time and attention between multiple boards, directors may also have to prioritize certain seats over others. Masulis and Mobbs (2014) find that directors focus their efforts on the largest firms within their portfolios. 2

5 divert attention and effort away from their board responsibilities? We use meeting attendance as a measure of director effort. Second, we focus on firm outcomes directly linked to the audit committee. We look at whether a shock to the busyness of the audit committee affects the earnings quality of the firms on which they serve. We start with a sample of firms that have a major event (defined as a shareholder lawsuit or merger and acquisition activity) and classify all CEOs and directors at those firms as having a distraction. We then determine other firms where the distracted CEOs and directors serve as independent directors on the board. This is our sample of distracted directors. We do not include any firms where a major event occurs in our sample. In other words, we only look at the firms where directors are distracted from, not the firm that is creating the distraction. Our main findings are as follows. First, we confirm prior research and show that distracted directors, in general, are more likely to miss more board meetings. We also separate our distracted directors based on if they are CEOs, insiders, or independent directors at the firm where a distracting event occurs. We show that the more important the position they have at the firm with the distracting event, the more likely they are to miss board meetings at their other firms in our sample. Next, we focus on the audit committee. Focusing on the audit committee allows us to more clearly tie director distraction to negative performance. We show audit-committee members are more likely to miss board meetings when they are distracted as opposed to other committee members. Linck, Netter and Yang (2008) show that SOX increased both the workload of, and risk faced by directors. Therefore, we separate our sample period into a pre-sox and post-sox sample. We find that the effect of director distraction occurs in the post-sox period but not the 3

6 pre-sox period. This indicates that distractions are more important following SOX when major events may have an even greater impact on workload. Our emphasis on the audit committee allows us to focus on firm outcomes that are primarily due to audit committee monitoring. Since financial reporting quality is primarily under the purview of the audit committee, we focus on earnings quality. We take the absolute value of discretionary accruals using the Jones (1991) model. We find that earnings quality declines when audit committee members are distracted. Our paper contributes to the literature on directory busyness and, in particular, the emerging literature on distracted directors. Masulis and Zhang (2017) show that every year, 22% of independent directors are preoccupied (distracted). They show that preoccupied directors are more likely to miss board meetings and are more likely to give up their less prestigious directorships. Masulis and Zhang (2017) then show that firms with more preoccupied directors have lower firm value and poorer performance when undertaking merger and acquisition activity. Like Masulis and Zhang (2017), Wang and Verwijmeren (2017) show that firms with distracted directors have more inactive directors and have a decline in firm value. Stein and Zhao (2016) show that firms with distracted directors have lower returns and a decline in value and poorer governance. Brown, Dai, and Zur (2016) find that earnings quality improves when board members become less busy. Our paper differs from these papers in that our emphasis is on how distractions affect the audit committee s monitoring ability. Focusing on the audit committee is important for multiple reasons. Since the audit committee has responsibility for overseeing the earnings quality of the firm, we are able to more clearly link firm outcomes to the director distractions. Second, there is an emerging literature focusing on the busyness of the audit committee. Sharma and Iselin 4

7 (2012) find that audit committee members serving on multiple board of directors leads to an increase in financial restatements in the post-sox period. Tanyi and Smith (2015) find that the effect of busyness is only captured if the chair or financial expert serves on multiple boards. These boards are associated with lower financial reporting quality. Our paper fills a gap by disentangling the busyness of the audit committee into distracted time periods and non-distracted time periods. Our paper contributes to the literature on director busyness and audit committee effectiveness. An important implication of our paper is that while the implementation of SOX has increased the qualifications of audit committee members, the tradeoff of their expertise may be outweighed by additional demands placed on their time. The remainder of the paper is organized as follows. In section 2, describe the data used in this paper and discuss our methodology. Section 3 presents our main results and we conclude in Section 4. 2 Data and methodology We start building our sample by identifying distracting events during the sample period from 1996 to The three major events we use are shareholder lawsuits, being the target or being the acquirer in merger and acquisition activity. We use all shareholder lawsuits available on the Securities Class Action Clearinghouse at Stanford University. Following Harford and Schonlau (2013), we impose certain filters on merger and acquisition activity to ensure that the events are significant enough to require time and effort expended by the CEO and directors. From SDC Platinum, we only include M&A deals that are completed, have a deal size larger than $50 million and have a relative deal size of the target to acquirer of at least 5%. Table 1 5

8 presents the number of distracting events over our sample period. Only the events with distracted independent directors at non-event firms are included in this table. After identifying the distracting events, we obtain the CEOs and directors (both inside and independent) at these firms from ExecuComp and ISS RiskMetrics. We then match these individuals to independent directors in the ISS RiskMetrics director dataset, identifying them as distracted directors. We note that firms with at least a distracting event are deleted from the sample in the matching stage, so firms remaining in the sample are those without any distracting event. Distracted directors are defined as those experiencing a distracting event at another firm at the same time (either as a CEO or as a director). Our sample includes directors at S&P 1500 firms from 1996 to Director-firm-year observations at firms with distracting events are deleted from the sample, leaving us with 184,128 director-firm-year observations. All data on director characteristics are obtained from ISS RiskMetrics, while financial data are obtained from Compustat. Definitions and sources of our variables are reported in Appendix A. Table 2 presents summary statistics for our sample for all independent director-firm years, all distracted director-firm years, and all non-distracted director-firm years. Overall, we see that distracted directors are more likely to attend less than 75% of board meetings (2.59% vs 1.58% for all independent directors and 1.51% for all non-distracted directors). The percent serving on different committees (audit, compensation, nominating, and governance) are all similar as are the number of committees, director age, and director tenure. The number of independent directorships held by distracted directors (2.75) is larger than for all independent directors (1.49) and all non-distracted directors (0.84). This is by construction, as being an independent director at another firm is one of our criteria for determining distracting events. 6

9 3 Results We first test to see if distractions to audit committee members cause them to divert their attention and effort away from board responsibilities. To do this, we analyze what happens at the director level. We present this analysis in section 3.1. The second research question we answer is what happens to the earnings quality of firms whose audit committee members are distracted. This analysis is done at the firm level and is presented in section Director Level We report the univariate analysis of board meetings missed in Table 3. Our variable of interest is an indicator variable equal to one (1) if the director attends less than 75% of the meetings and zero (0) otherwise. We separate the sample into distracted directors and nondistracted directors. Panel A reports results for all independent directors. For all independent directors, distracted directors are more likely to attend less than 75% of board meetings (that is, miss more). Of the distracted directors, 2.59% attend less than 75% of meetings while of the non-distracted directors, 1.51% attend less than 75% of meetings. The difference of 1.08% is significant at the 1% level. In Table 3, Panel B, we separate the audit-committee and compare these directors to nonaudit committee directors. We find a similar pattern in that distracted directors are more likely to attend less than 75% of meetings (audit committee members 2.28% and non-audit committee members 2.80%) compared to non-distracted directors (audit committee members 1.08% and non-audit committee members 1.89%). For both groups, the difference between distracted and non-distracted directors is significant. The difference for the audit committee (1.20%) is larger than the difference for the non-audit committee (0.90%) but not statistically significant. 7

10 Table 3, Panel C reports the percent of directors who attend less than 75% of board meetings by distraction-type and by the position held at the event firm. The percent of distracted directors by distraction-type are similar, indicating our results are not being driven by a specific event. CEO s and inside directors at the event firm are more likely to attend less than 75% of board meetings (4.23% and 4.75% respectively) than independent directors at the event firm (2.06%). This is due to CEOs and inside directors facing a bigger shock to their effort when a major event occurs than an independent director. Sarbanes-Oxley has changed the workload and risk of directors (Linck, Netter, and Yang (2008)). This is particularly important for the audit committee as financial reporting standards also changed. Therefore, we separate our sample into pre-sox and post-sox time periods to see how distraction matters. We expect distractions to have a bigger impact following the passage of SOX because SOX increases the financial reporting standards and workload of board members. We report univariate results around SOX in Table 4. Panel A reports our pre-sox sample which covers Panel B reports our post-sox time period ( ). First, we notice that SOX has an impact on board meeting attendance. Regardless of whether the director is a member of the audit committee or not and whether they are distracted or not, they are less likely to attend less than 75% of board meeting following the passage of SOX. In the pre-sox period, both audit and non-audit committee members who are distracted are more likely to attend less than 75% of board meetings (4.15% for non-audit and 3.58% for audit committee members respectively) than non-distracted directors (3.48% for non-audit and 2.57% for audit committee members). Both differences are statistically significant. We also employ a difference-indifference measure. We first take the difference between distracted and non-distracted directors 8

11 and then take the second difference between the non-audit and audit committee members. In the pre-sox period, this diff-in-diff (-0.34%) is not statistically significant. In Panel B of Table 4, we report results for the post-sox period. Table 4 reports no statistically significant difference between distracted and non-distracted non-audit committee members (1.29% for distracted and 1.13% for non-distracted). However, distracted audit committee members are more likely to attend less than 75% of board meetings (1.46%) than nondistracted audit-committee members (0.72%) following the passage of SOX. The difference of 0.73% is significant at the 1% level. The difference in difference of the non-audit committee members and audit committee members is -0.57% and significant at the 5% level. Therefore, following the passage of SOX, distractions appear to affect the audit committee members only but no other director committees. We report multivariate analysis in Table 5. Our main model is at the director-year level and is a probit regression where the dependent variable is a dummy variable equal to 1 if the director attends less than 75% of board meetings and zero otherwise. Our main variables of interest are a dummy variable equal to 1 if the director is distracted and zero otherwise, a dummy variable equal to 1 if the director serves on the audit committee and zero otherwise, and an interaction between the two. Following Masulis and Mobbs (2014), we also control for whether the directorship is highly sought after, whether this is the only directorship they hold or the number of directorships held. We also control for director tenure, board size, director age, director ownership, firm size, ROA, and Tobin s Q. All variables are defined in Appendix A. Panel A reports results for the full sample, and includes a Post-SOX dummy variable. In Panel B and C, we separate our sample into Pre-SOX (Panel B) and Post-SOX (Panel C). We do not include a SOX dummy variable in these two panels. 9

12 Table 5, Panel A reports the full sample results. First, we see that the sign of the coefficient on the distracted director dummy is always positive, however it is only significant in model 1. This indicates that being distracted does not have a general impact on meeting attendance. Next, we clearly see that audit committee members are less likely to attend less than 75% of board meetings than non-audit directors. The coefficient on the audit committee member dummy is negative and significant in all models. Third, distracted audit committee members are more likely to attend less than 75% of board meetings. In all models, the coefficient is positive and significant. These results indicate that director distraction is important to being an active board member if one serves on the audit committee but is less important for non-audit committee members. In Panel B of Table 4, we report multivariate results for the pre-sox time period. We still see that audit committee members are less likely to attend less than 75% of board meetings. However, the effect of distraction on board meeting attendance is insignificant for all directors as well as for the audit committee members. In Panel C of Table 4, we report multivariate results for the post-sox time period. Again, audit committee members are less likely to attend less than 75% of board meetings. We also see that distracted directors in general does not have an impact on board meeting attendance. However, when we look at the interaction between distracted directors and audit committee members, we see that distracted audit committee members are more likely to attend less than 75% of board meetings. In all models, the coefficient is positive and significant at either the 5% or 1% levels. Overall, there is a clear effect from SOX on how director distraction affect board meeting attendance. From the univariate results, we see that following the passage of SOX, directors are less likely to attend less than 75% of board meetings. We interpret this that directors time is 10

13 being stretched too thin following the passage of SOX. Therefore, when a major event occurs, they have no choice but to miss more meetings. This is even more rampant for the audit committee as they are less likely to attend less than 75% of board meetings than non-audit committee members in general. 3.2 Firm Level Outcomes Distracted directors, and, in particular, distracted audit committee members are more likely to attend less than 75% of board meetings. We now analyze what happens to financial reporting quality of firms with distracted directors (audit committee members). The audit committee has key oversight over the firm s financial reporting quality. Therefore, we focus on the earnings quality of firm s with distracted audit committee members. To achieve this analysis, we now focus on firm-years as opposed to firm-director-years. Table 6 reports summary statistics at the firm-year level. In our sample, 28.3% of firmyears have at least one distracted director. Roughly 6% of independent directors are distracted each year, with 2.56% serving on the audit committee. Our distracted director sample is relatively smaller than Masulis and Zhang (2017), who report 22% of all independent directors being preoccupied each year. 3 Our methods to identify outside events are different. However, to the extent that we miss distracting events, this biases against our finding an impact on firm outcomes. On average, firms have 7.6 board meetings per year, have a board size of 9.4, and have a board made up of about 70% independent directors. Our main variable of interested is the absolute value of discretionary accruals. We use this as a proxy for earnings quality ({Tanyi, 2015 #1}). We estimate discretionary accruals using 3 While our terminology differs, distracted and preoccupied are effectively the same. 11

14 the Jones (1991) model and take the absolute value of our estimated discretionary accruals as our measure of earnings quality. The larger this value, the lower the earnings quality is of the firm. Table 7 reports our multivariate regression results. The dependent variable is the absolute value of discretionary accruals (as measured by the Jones (1991) model). Our main variables of interest are the percent of the audit committee that is distracted (models (1) and (4)), the percent of all independent directors who are distracted (models (2) and (5)), and both the percent of all independent directors who are audit committee members and who are non-audit committee members (models (3) and (6)). We control for firm size, ROA, Tobin s Q, leverage, board size, CEO ownership, CEO tenure, CEO/chair duality, and the percent of independent directors. In models (4)-(6) we include firm fixed effects. All variables are defined in Appendix A. We first analyze only the audit committee and find that the larger the percent of audit committee members who are distracted, the lower the earnings quality (a larger absolute value of discretionary accruals). The coefficient is positive and significant at the 10% level in both models (1) and (4). Next, we look at the entire group of independent directors. In models (2) and (5), we report results where our main variable of interest is the percent of all independent directors who are distracted. The relationship is positive, but only significant when we do not include firm fixed effects in model (2) at the 10% level. We decompose the independent directors into audit committee members and non-audit committee members (models (3) and (6)), we find that it is distracted audit-committee members that influence earnings quality. In both model (3) and model (6), the coefficient on the percent of independent directors who are distracted audit committee members is positive and significant at the 5% level. However, the percent of independent directors who are distracted non-audit committee members is insignificant. Taken as a whole, these results imply that when audit 12

15 committee members are distracted, managers are more likely to manage earnings (either up or down), reducing the quality of earnings reported. 4 Conclusion A key function of the audit committee is to monitor and provide advice to management as it pertains to financial statement quality. In this paper, we show that the attention the audit committee pays towards their board work is affected by events occurring at other firms they are associated with. Firms that have distracted audit committee members have a reduction in earnings quality. This paper contributes to the literature on busy directors and director attention. We show that audit committee members are more likely to be impacted by distracting events than nonaudit committee members. Prior literature has focused on the board of directors as a whole. We also show that the passage of SOX has had an impact on how directors are able to allocate their time. Finally, firms with more distracted audit committee members have lower earnings quality. For shareholders and policy makers, an important implication of our paper is that there is a tradeoff between hiring more experienced directors and the time they have to devote to monitoring and advising management. 13

16 References Beasley, Mark S, 1996, An Empirical Analysis of the Relation between the Board of Director Composition and Financial Statement Fraud, The Accounting Review Brown, Anna Bergman, Jing Dai, and Emanuel Zur, 2016, The Effect of Director Busyness on Monitoring and Advising: Evidence from a Natural Experiment, (Working Paper). Dechow, Patricia, Weili Ge, and Catherine Schrand, 2010, Understanding Earnings Quality: A Review of the Proxies, Their Determinants and Their Consequences, Journal of Accounting and Economics 50, Fama, Eugene F, 1980, Agency Problems and the Theory of the Firm, Journal of Political Economy 88, Ferris, Stephen P, Murali Jagannathan, and Adam C Pritchard, 2003, Too Busy to Mind the Business? Monitoring by Directors with Multiple Board Appointments, The Journal of Finance 58, Fich, Eliezer M, and Anil Shivdasani, 2006, Are Busy Boards Effective Monitors?, The Journal of Finance 61, Harford, Jarrad, and Robert J Schonlau, 2013, Does the Director Labor Market Offer Ex Post Settling-up for Ceos? The Case of Acquisitions, Journal of Financial Economics 110, Hauser, Roie, forthcoming, Busy Directors and Firm Performance: Evidence from Mergers, Journal of Financial Economics. Jones, Jennifer J, 1991, Earnings Management During Import Relief Investigations, Journal of Accounting Research Linck, James S, Jeffry M Netter, and Tina Yang, 2008, The Effects and Unintended Consequences of the Sarbanes-Oxley Act on the Supply and Demand for Directors, The Review of Financial Studies 22, Masulis, Ronald W, and Shawn Mobbs, 2014, Independent Director Incentives: Where Do Talented Directors Spend Their Limited Time and Energy?, Journal of Financial Economics 111, Masulis, Ronald W, and Emma Jincheng Zhang, 2017, Preoccupied Independent Directors, working paper. Sharma, Vineeta D, and Errol R Iselin, 2012, The Association between Audit Committee Multiple-Directorships, Tenure, and Financial Misstatements, Auditing: A Journal of Practice & Theory 31,

17 Stein, Luke CD, and Hong Zhao, 2016, Distracted Directors, working paper. Tanyi, Paul N, and David B Smith, 2015, Busyness, Expertise, and Financial Reporting Quality of Audit Committee Chairs and Financial Experts, Auditing: A Journal of Practice & Theory 34, Wang, Renjie Rex, and Patrick Verwijmeren, 2017, Director Attention and Firm Value, working paper. Ward, Ralph D, 2009, Audit Committee Leaders Face Increasing Workload, Financial Executive 25,

18 Appendix A Definitions and sources of data used in this study This appendix presents the definitions and sources of all variables used in this study Director-firm-year level variables: Variable Definition Source(s) Attend less than 75% of board meetings Distracted director Indicator variable in the ISS RiskMetrics database Indicator variable equal to 1 if the director is experiencing a distracting event (lawsuit, merger, or acquisition) at another directorship ISS RiskMetrics ISS RiskMetrics, Thomson Reuters SDC M&A, Securities Class Action Clearinghouse at Stanford University ISS RiskMetrics Audit committee member Member or chairman of the audit committee Director tenure Number of years a director has served ISS RiskMetrics on the board Director age Director age ISS RiskMetrics Director ownership Percent of common shares outstanding ISS RiskMetrics held by the director, including fully exercised stock options Number of independent directorships Sole directorship High-ranked directorship Number of total independent directorships held by the director within the ISS RiskMetrics dataset Indicator variable equal to 1 if this directorship is the director s only directorship Indicator variable equal to 1 if this directorship is at least 10% larger than the director s smallest directorship as measured by market capitalization ISS RiskMetrics ISS RiskMetrics ISS RiskMetrics 16

19 Firm-year level variables: Variable Definition Source(s) Absolute value of Jones model (see below) Compustat discretionary accruals Percent of audit Number of distracted directors divided ISS RiskMetrics committee who are distracted by number of directors on audit committee Percent of independent Number of distracted directors divided ISS RiskMetrics directors who are distracted by number of independent directors Percent of independent Number of directors who are both ISS RiskMetrics directors who are distracted and audit committee members distracted and on audit committee divided by number of independent directors Percent of independent Number of directors who are both ISS RiskMetrics directors who are distracted and nonaudit committee members distracted and not audit committee members divided by number of independent directors Number of board meetings Number of times the board meets during the year ExecuComp, Corporate Library Log(Assets) Natural log of total assets (AT) Compustat Return on Assets Operating Income/Assets (variable Compustat (ROA) OIBDP/AT in Compustat) Tobin s Q (Total assets book value of equity + Compustat market value of equity) / Total Assets (AT - sum(seq, TXDB, ITCB, -PREF) + PRCC_C*CSHO)/AT Market leverage (Long-term debt + Current debt)/(total Compustat Assets Book equity + Market cap) (DLTT+DLC)/(AT CEQ + PRCC_F*CSHO) Board size Number of directors on the board ISS RiskMetrics Percent independent Number of independent directors on the ISS RiskMetrics directors board/ Board size CEO ownership Percent of common shares outstanding at fiscal year-end owned by the CEO Execucomp and Compustat CEO tenure Current year minus year became CEO Execucomp CEO-Chairman duality Indicator variable equal to 1 if the CEO also serves as Chairman of the board Execucomp 17

20 Jones Model (Jones (1991)) For each 2-digit SIC industry group, we estimate equation (1) annually, requiring at least 8 observations for each industry-year combination and winsorize all of the regression variables at the 1% level. (ibc cfo) i,t 1 sales = β at 1 + β i,t ppe i,t 1 at 2 + β i,t i,t 1 at 3 + ε i,t 1 at i,t (1) i,t 1 Firm-specific discretionary accruals (DA) are computed as the residual from equation (1). Variable Definition Compustat data item ibc Earnings before extraordinary items ibc cfo Cash flow from operations oancf xidoc at Total assets at sales Change in sales sales ppe Gross Property, Plant, and Equipment ppegt 18

21 Table 1: Number of distracting events over time This table presents the number of distracting events (lawsuits, acquisitions, and mergers) over our sample period from 1996 to We start with obtaining all CEOs, inside directors, and independent directors at event firms as of the fiscal year end before the event date. We match this sample to independent directors at non-event firms in the S&P 1500 (firms that do not experience a lawsuit or acquisition/merger). Only the events with distracted independent directors at non-event firms are included in this table. Lawsuits are obtained from the Securities Class Action Clearinghouse at Stanford University, whereas mergers and acquisitions are obtained from Thomson Reuters SDC M&A dataset. Year Number of lawsuits Number of acquirers Number of targets Total

22 Table 2: Summary statistics of independent directors at non-event firms This table reports means and medians for various variables at the director-firm-year level. The sample includes all independent directors at S&P 1500 firms from 1996 to 2015, excluding firms with distracting events (lawsuits, mergers, or acquisitions). Distracted directors are defined as those experiencing a distracting event at another firm at the same time. Lawsuits are obtained from the Securities Class Action Clearinghouse at Stanford University, whereas mergers and acquisitions are obtained from Thomson Reuters SDC M&A dataset. Data on directors and their characteristics are obtained from the ISS RiskMetrics dataset. Definitions and sources for all variables are reported in Appendix A. Independent directors Distracted directors Non-distracted directors Variable Obs Mean Median Obs Mean Median Obs Mean Median Attend less than 75% of board 184, , , meetings Distracted director 184, , , Distracted audit committee member 184, , , Distracted audit committee chair 184, , , Distracted financial expert 91, , , Distracted by lawsuit 184, , , Distracted by an acquisition 184, , , Distracted by being a target 184, , , Audit committee member 184, , , Compensation committee member 184, , , Nominating committee member 184, , , Corporate governance committee 184, , , Number of committees 184, , , Director age 183, , , Director tenure 167, , , Director ownership 167, , , Number of independent directorships 184, , , Sole directorship 184, , ,

23 Table 3: Univariate tests of meeting attendance This table demonstrates the impact of distractions on independent directors frequency of attending meetings. The sample includes all independent directors at S&P 1500 firms from 1996 to 2015, excluding firms with distracting events (lawsuits, mergers, or acquisitions). Distracted directors are defined as those experiencing a distracting event at another firm at the same time. Lawsuits are obtained from the Securities Class Action Clearinghouse at Stanford University, whereas mergers and acquisitions are obtained from Thomson Reuters SDC M&A dataset. Our sample includes all independent directors at non-event firms (S&P 1500) from 1996 to Data on meeting attendance and committee memberships are obtained from the ISS RiskMetrics dataset. Panel A Distracted directors All independent directors at non-event firms Non-distracted directors Difference in means p-value for t-test Percent of directors attending less than 75% of meetings 2.59% 1.51% 1.08% 0.000*** Number of observations 11, ,262 Panel B Audit committee members at non-event firms Percent of directors attending less than 75% of meetings 2.28% 1.08% 1.20% 0.000*** Number of observations 4,823 82,201 Non-audit committee members at non-event firms Percent of directors attending less than 75% of meetings 2.80% 1.89% 0.90% 0.000*** Number of observations 7,042 90,061 Panel C Distracted directors at non-event firms only By event type (number of observations in parenthesis) Lawsuit 2.20% (3,585) Acquirer 2.79% (8,102) Target 2.83% (918) Distracted directors at non-event firms only By director type at event firms CEOs 4.23% (899) Inside directors 4.75% (2,360) Independent directors 2.06% (9,709) 21

24 Table 4: Univariate tests of meeting attendance in the pre-sox and post-sox periods Table 4 provides the results of a difference-in-differences univariate test comparing audit committee members and non-audit committee members with regards to the percentage of directors attending less than 75% of board meetings. The sample includes all independent directors at S&P 1500 firms from 1996 to 2015, excluding firms with distracting events (lawsuits, mergers, or acquisitions). Distracted directors are defined as those experiencing a distracting event at another firm at the same time. Panel A presents the diff-in-diff results for the pre-sox period, whereas panel B presents the diff-in-diff results for the post-sox period. Data on meeting attendance and committee memberships are obtained from the ISS RiskMetrics dataset. T-statistics are reported in parenthesis. Panel A: Pre-SOX subsample period ( ) Distracted directors Non-audit committee members 4.15% 3.48% 0.67% (2.17)** Audit committee members 3.58% 2.57% 1.00% (2.33)** Panel B: Post-SOX subsample period ( ) Non-distracted directors 1 st diff Diff-in-diff Distracted directors Non-audit committee members 1.29% 1.13% 0.16% (0.94) Audit committee members 1.46% 0.72% 0.73% (4.05)*** -0.34% (0.63) Non-distracted directors 1 st diff Diff-in-diff -0.57% (2.29)** 22

25 Table 5: Multivariate regression of meeting attendance This table presents results from probit regressions of meeting attendance by directors at S&P 1500 firms over the sample period , excluding firms with distracting events (lawsuits, mergers, or acquisitions). Distracted directors are defined as those experiencing a distracting event at another firm at the same time. The dependent variable is an indicator variable equal to 1 if the director attends less than 75% of board meetings. Panel A presents results for the full sample, whereas Panel B and Panel C present results for the pre-sox period and post-sox period subsamples, respectively. Standard errors are clustered at the director level. Definitions and sources for all variables are reported in Appendix A. Panel A: Full sample ( ) Dependent Variable Attend less than 75% of board meetings (1) (2) (3) (4) Distracted director (2.8)*** (1.2) (0.8) (0.2) Audit committee member (-12.0)*** (-11.8)*** (-6.5)*** (-6.5)*** Distracted audit committee member (2.3)** (2.6)*** (2.2)** (2.3)** High ranked directorship (-5.8)*** (-6.5)*** (-3.9)*** (-3.8)*** Sole directorship (-7.9)*** (-5.8)*** Number of directorships (8.5)*** (5.2)*** Director tenure (-1.2) (-1.3) Board size (8.7)*** (8.6)*** Ln(director age) (-5.1)*** (-5.2)*** Director ownership (1.2) (1.2) Post SOX (-19.0)*** (-18.6)*** Ln(market cap) (-6.8)*** (-6.7)*** ROA (-1.1) (-1.1) Tobin s Q (5.1)*** (5.2)*** Observations 184, , , ,632 Pseudo R-Squared

26 Panel B: Pre-SOX subsample period ( ) Dependent Variable Attend less than 75% of board meetings (1) (2) (3) (4) Distracted director (-0.1) (-0.5) (0.0) (-0.4) Audit committee member (-4.7)*** (-4.7)*** (-2.7)*** (-2.8)*** Distracted audit committee member (0.7) (0.8) (0.4) (0.6) High ranked directorship (-5.0)*** (-4.1)*** (-4.3)*** (-3.6)*** Sole directorship (-7.9)*** (-7.2)*** Number of directorships (5.6)*** (5.2)*** Director tenure (-0.6) (-0.5) Board size (7.1)*** (6.9)*** Ln(director age) (-2.2)** (-2.2)** Director ownership (0.8) (0.9) Ln(market cap) (-3.4)*** (-3.4)*** ROA (-2.1)** (-2.0)** Tobin s Q (3.2)*** (3.3)*** Observations 50,878 50,878 33,371 33,371 Pseudo R-Squared

27 Panel C: Post-SOX subsample period ( ) Dependent Variable Attend less than 75% of board meetings (1) (2) (3) (4) Distracted director (0.8) (0.6) (0.9) (0.6) Audit committee member (-6.8)*** (-6.8)*** (-6.3)*** (-6.3)*** Distracted audit committee member (2.5)** (2.5)** (2.6)*** (2.7)*** High ranked directorship (-3.3)*** (-3.6)*** (-1.6) (-1.8)* Sole directorship (-1.6) (-1.8)* Number of directorships (2.0)** (2.2)** Director tenure (-1.3) (-1.3) Board size (5.7)*** (5.7)*** Ln(director age) (-5.2)*** (-5.2)*** Director ownership (0.8) (0.8) Ln(market cap) (-6.0)*** (-5.9)*** ROA (-1.0) (-1.0) Tobin s Q (4.0)*** (4.0)*** Observations 133, , , ,281 Pseudo R-Squared

28 Table 6: Summary statistics of firm-year sample This table reports means and medians for various variables at the firm-year level. The sample includes S&P 1500 firms from 1996 to 2015, excluding firms with distracting events (lawsuits, mergers, or acquisitions). Distracted directors are defined as those experiencing a distracting event at another firm at the same time. Definitions and sources for all variables are reported in Appendix A. Number of Mean Median Std. Dev. Variables observations Firm has at least one distracted director 27, Percent of audit committee who are distracted 27, Percent of independent directors who are distracted 27, Percent of independent directors who are distracted and audit committee 27, members Percent of independent directors who are distracted and non-audit 27, committee members Absolute value of discretionary accruals 20, Number of board meetings during the year 20, Ln (assets) 27, ROA 26, Tobin s Q 27, Market leverage 27, Board size 26, Percent independent directors 26, CEO ownership 24, CEO tenure 24, CEO-Chairman duality 25,

29 Table 7: Multivariate regression of earnings management This table presents OLS and fixed effects regressions of earnings management on the percent of directors who are distracted. The sample includes S&P 1500 firms from 1996 to 2015, excluding firms with distracting events (lawsuits, mergers, or acquisitions). Distracted directors are defined as those experiencing a distracting event at another firm at the same time. The dependent variable is the absolute value of discretionary accruals. Discretionary accruals are computed using the Jones (1991) model. Definitions and sources for all variables are reported in Appendix A. Standard errors are clustered at the firm level. Dependent Variable Absolute value of discretionary accruals (1) (2) (3) (4) (5) (6) Percent of audit committee who are distracted (1.8)* (1.8)* Percent of independent directors who are distracted (1.7)* (1.2) Percent of independent directors who are distracted (2.2)** (2.1)** and audit committee members Percent of independent directors who are distracted (0.2) (-0.2) and non-audit committee members Ln (assets) (-3.2)*** (-3.2)*** (-3.2)*** (-1.6) (-1.6) (-1.7)* ROA (-1.6) (-1.6) (-1.6) (-1.0) (-1.0) (-1.0) Tobin s Q (3.8)*** (3.8)*** (3.8)*** (0.2) (0.2) (0.2) Market leverage (0.4) (0.4) (0.4) (-0.7) (-0.7) (-0.7) Board size (-0.7) (-0.8) (-0.6) (-0.9) (-1.0) (-0.8) Percent independent directors (1.2) (1.4) (1.3) (-1.1) (-1.1) (-1.1) CEO ownership (1.7)* (1.7)* (1.7)* (2.1)** (2.1)** (2.1)** CEO tenure (-3.1)*** (-3.1)*** (-3.1)*** (-2.4)** (-2.4)** (-2.4)** CEO-Chairman duality (1.5) (1.5) (1.5) (1.1) (1.1) (1.1) Firm Fixed Effects No No No Yes Yes Yes N 17,608 17,608 17,608 17,608 17,608 17,608 R