The Effect of Audit Committee Expertise, Independence, and Activity on Aggressive Earnings Management

TLDR

The study examines how audit committee expertise, independence, and activity influence the quality of publicly released financial information. The authors assess the link between audit committee characteristics and the magnitude of income‑increasing and income‑decreasing abnormal accruals as a proxy for earnings management. They find that aggressive earnings management is negatively associated with audit committee financial and governance expertise, independence, and a clear mandate, and that this relationship holds for both income‑increasing and income‑decreasing abnormal accruals.

Abstract

This study investigates whether the expertise, independence, and activities of a firm's audit committee have an effect on the quality of its publicly released financial information. In particular, we examine the relationship between audit committee characteristics and the extent of corporate earnings management as measured by the level of income-increasing and income-decreasing abnormal accruals. Using two groups of U.S. firms, one with relatively high and one with relatively low levels of abnormal accruals in the year 1996, we find a significant association between earnings management and audit committee governance practices. We find that aggressive earnings management is negatively associated with the financial and governance expertise of audit committee members, with indicators of independence, and with the presence of a clear mandate defining the responsibilities of the committee. The association is similar for both income-increasing and income-decreasing earnings management, suggesting that audit committee members are concerned with both types of earnings management and do not exhibit an asymmetric loss function similar to that of auditors.