Board of Director Effectiveness and Earnings Conservatism: Preliminary Australian Analysis

Transcription

1 Board of Director Effectiveness and Earnings Conservatism: Preliminary Australian Analysis Abstract: The study s overarching objective is to examine influence of board of director effectiveness on the extent of earnings conservatism amongst Australian listed firms. The study collected data from a sample of 100 Australian publicly listed firms stratified-randomly selected based on market capitalization to reduce size-biases. Data is collected for the 2008 financial year. Empirical results indicate more effective board of directors a more likely to incorporate negative news into earnings significantly faster (i.e., more timely) than less effective board of directors. This implies firms with more effective board of directors are more likely to report more reliable accounting information than firms with less effective board of directors. Additional analysis also shows that board of directors that are more independent, have independent members who are financially qualified and meet more frequently were more likely to be associated with disclosure of negative news in a more timely manner. However, results show board of directors composed of at least one independent director with prior committee experience were just as likely to report negative news in a similar time frame as board of directors without such experienced members. 1. Introduction and background Conservatism is one of the principal foundations of financial accounting with a longstanding and substantial influence. 1 Empirical research indicates that conservatism has increased in the past three decades (Balkrishna, Coulton, and Taylor, 2007; Givoly and Hayn, 2002; Givoly and Hayn, 2000; Huijgen and Lubberink, 2005; Krishnan and Visvanathan, 2007a). Despite the longevity and reputed importance of conservatism, capital market regulators, accounting standard-setters and scholars frequently criticize conservatism. 2 The lengthy survival and resilience to criticism, nonetheless, strongly suggests conservatism has significant benefits overlooked by critics. Whilst there is a need to determine and understand the benefits of conservatism, there is also a significant need to identify factors influencing conservatism. Identifying determinants of conservatism is essential because though capital market regulators and accounting standard-setters may not directly seek to eliminate conservatism, actions affecting the determinants of conservatism could have serious indirect repercussions on financial reporting quality. The need to understand determinants of conservatism has been amplified in the past decade following major corporate financial accounting scandals. It has long been acknowledged corporate management have strong incentives to overstate earnings (Fama, 1980; Jensen and Meckling, 1976). However, escalating pressures during the past decade to meet investor and market expectations for higher revenues and earnings is thought to be increasingly enticing corporate management to adopt more aggressive financial accounting practices. Consequently, this undermines conservatism and the quality of earnings (LaFond and Watts, 2008). A majority of prior research examining determinants of conservatism has concentrated on the influence of institutional factors (Ball, Kothari, and Robin, 2000; Grambovas, Giner, and Christodoulou, 2006; Lara, Osma, and Mora, 2005). Mounting attention to corporate governance 1 Conservatism is an open-ended phrase that is frequently used to refer to various concepts such as earnings conservatism and balance sheet conservatism. The author acknowledges the broad use of this phrase but within the specific context of this study, unless stated, conservatism is used purely from an earnings conservatism point of view. Other forms of conservatism, if used, will be prefixed by a leading word to describe the other form of conservatism. 2 This is because the persistent asymmetric treatment of gains and losses is argued to lead to understatements in the current period that prompt the overstatement of earnings in future periods via the understatement of future expenditure. 1 P a g e

2 issues in the past decade has spurned a new stream of investigation examining the impact of corporate governance mechanisms on conservatism. To date, much attention in this new stream has concentrated on ownership structure, the auditing process, and audit firms and fees (Ahmed and Duellman, 2007; Beekes, Pope, and Young, 2004; Hamilton, Ruddock, Stokes, and Taylor, 2005; Lafond and Roychowdhury, 2008; Ruddock, Taylor, and Taylor, 2006). Other key corporate governance mechanisms, pivotal to the financial accounting process, however, may likely be of significance but as yet have received little, if any, attention. The board of directors is one such feature. Board of directors have been placed at the centre stage of the global debate on corporate governance reforms since the early 1990s (Blue Ribbon Committee, 1999; Corporate Governance Committee, 2001; New York Stock Exchange and National Association of Securities Dealers, 1999). Whilst boards of directors are acknowledged as the ultimate corporate governance mechanism for monitoring the financial reporting process, responsibility for the general and day-to-day oversight is increasingly delegated to the board of directors. The introduction of new corporate governance regulations such as the ASX Corporate Governance Council Recommendations (ASX 2003) and the Corporations Law Economic Reform Programme 9 (CLERP 9) have served to increase the responsibilities and influence of board of directors in the financial reporting process. Given the unprecedented and ever increasing interest in earnings by investors, combined with escalating demands for higher quality earnings, there is an urgent need to identify influential factors and the resulting impact on earnings. As discussed above, both the conservatism principle and the board of directors are alleged to have a significant bearing on earnings (Beasley and Salterio, 2001; Klein, 2002a; Watts, 2003). Currently the influence of a board of directors and its effectiveness on conservatism (and ultimately earnings quality) remains an open empirical question that has not been formally investigated. A pivotal aim of this study is to address this void in the extant literature surrounding conservatism and the board of directors. Studying board of director effectiveness/earnings conservatism linkage is important and timely. Presently, international capital markets (including Australia) are highly volatile, raising questions about earnings quality. Understanding the board of director effectiveness/earnings conservatism link, and the impact on earnings quality, assists regulators derive strategies to restore credibility in earnings. More generically, corporate governance is continuously under reform. Studying the earnings conservatism/board of director effectiveness linkage, therefore, is of value as results will determine whether there is a likelihood any changes to regulations governing board of directors will impact on conservatism and earnings quality. Considering the earnings conservatism/board of director effectiveness linkage in the context of Australia is also of interest. For example, corporate governance has been a hot-bed of debate with the introduction of regulations such as ASX 2003 and CLERP 9. The effectiveness and impact of these corporate governance reforms is still a matter of debate. Findings from this study will aid in shedding new light and understanding on the debate. Also, the study focuses on Australia because of the (a) paucity of existing research examining the relationship between board 2 P a g e

3 of directors and financial reporting quality in Australia, and (b) mixed empirical results to date using data from this nation (Francis and Stokes, 1986; Goodwin, 2003; Stewart and Munro, 2007). The primary objective of this study is to examine the association between board of director effectiveness and earnings conservatism of Australian publicly listed firms. There is currently a lack of consensus in the extant literature of a precise definition or factors determining board of director effectiveness. Corporate governance advocates generally argue structural and operational composition factors influence a board of director s effectiveness. For example, in respect to structural composition, Klein (2002a) argues more independent board of directors are effective in constraining managerial opportunism, thereby, leading to greater quality of reported earnings. In the case of operational composition, Abbott and Parker (2000a) and Abbott et al., (2003) state more diligent board of directors (i.e., meet more frequently) are better able to address key financial reporting issues such as earnings management and financial misstatement. In line with prior literature (Beasley and Salterio, 2001; Van der Zahn and Tower, 2004) this study focuses on four prime components underlying board of director effectiveness: (a) sub-committee independence; (b) financial expertise; (c) experience; and (d) diligence. Overall, this study will benefit 1) firms in determining the optimal composition of board of directors, 2) policymakers and investors by identifying the impact of board of director features; and 3) regulators in determining the true role board of directors play in improving the level of earnings quality reported by firms and therefore, the integrity of the financial reporting process. Finally, findings from this study can be the basis of a more structured and systematic approach to board of director formation and the ability of the board of director to uphold key regulatory reforms. 2. Literature Review and Hypotheses Development Scholars have a lengthy history of supporting the importance of board of directors to the financial accounting process including influencing earnings quality (e.g., Beasley and Salterio, 2001; Pincus, Rusbarsky, and Wong, 1989). It is argued the central role of the board of director is to reduce the magnitude of positive or negative abnormal accruals, thereby, enhancing earnings quality. The board of director s ability to accomplish any required and/or perceived roles and responsibilities in monitoring the financial reporting process will depend primarily upon the sub-committee s effectiveness. Despite extensive debate there is little empirical research surrounding the issue of a board of director s effectiveness. Aside from studies focusing on earnings management, very few empirical studies have sought to determine the influence of board of director effectiveness on other aspects of financial accounting such as conservatism. The conservatism concept is an effective governance mechanism. Watts (2003), for example, suggests that the use of conservative accounting figures in contractual arrangements amongst various parties associated with the firm reduces information asymmetry and moral hazard problems derived from agency conflicts. A growing number of researchers (Ahmed and Duellman, 2007; Beekes et al., 3 P a g e

4 2004; Lara et al., 2005) argue other corporate governance mechanisms may provide an additional layer of conservatism important in determining earnings quality. Actions by regulators affecting corporate governance mechanisms, therefore, could inadvertently affect conservatism and earnings quality. 2.1 Theoretical Perspective Since Jensen and Meckling s (1976) seminal work developing a theory of the firm based on conflicts between contracting parties, a vast body of literature has developed explaining the nature of the conflicts and means by which conflicts may be resolved. This theoretical perspective, commonly known as agency theory, is strongly linked to earnings conservatism and board of directors role and responsibilities. Watts (1992), for example, suggests conservatism likely evolved from accounting s contracting role. Watts (1992) argues accounting conservatism helps avoid inappropriate distributions to claim holders. Basu (1997) suggests the conservatism principle evolved with audited financial statements as a means of management bonding that prevents management exploiting information asymmetry (a premise of Fama's 1980, agency theory). Ahmed et al., (2002) support the conservatism and contractual arrangements link (and, in turn, agency theory). Specifically, Ahmed et al.,(2002) argue conservatism mitigates conflicts of interest over dividend policy between shareholders and bondholders. Finally, Watts (2003) expresses the view earnings conservatism is a component of efficient contracting that restricts management s opportunistic behaviour in contracting purposes. In the case of board of directors, agency theorists strongly argue the board of directors is a pivotal governance mechanism to mitigate conflicts between contractual parties. Carcello and Neal (2000), for example, suggest a board of directors plays an important monitoring role. Beasley (1996), for example, argues a board of directors is an effective monitoring mechanism in assuring the quality of financial reporting and corporate accountability. This view is supported by others such as Carcello and Neal (2000), Klein (2002a) and Van der Zahn and Tower (2004). Given the close association of conservatism and board of directorss to contractual arrangements and agency conflicts, agency theory provides the study s underlying theoretical perspective. 2.2 Earnings Conservatism Various renowned scholars (Ball and Shivakumar, 2005; Francis, LaFond, Olsson, and Schipper, 2005; Watts, 2003) consider earnings conservatism a central indicator of earnings quality or a desirable property of accounting earnings. Therefore, studies have examined the different aspects of conservatism including existence, time series pattern, and determinants of conservatism (Basu, 1995; 1997; Givoly and Hayn, 2000; Lubberink and Huijgen, 2001; Givoly and Hayn, 2002; Penman and Zhang, 2002; Lobo and Zhou, 2006; Ruddock et al., 2006; Givoly et al., 2007; Krishnan, 2007; Krishnan and Visvanathan, 2007a; Roychowdhury and Watts, 2007). The existence of earnings conservatism is strongly supported by the seminal study by Basu (1997). After the groundbreaking findings of Basu (1997), Pae, Thornton and Welker (2005) found 4 P a g e

5 that earnings were conservative in all periods examined. Similarly, Balkrishna, Coulton and Taylor (2007b) sought to provide evidence of earnings conservatism in the financial reporting practices of Australian firms. Apart from providing evidence about the existence of earnings conservatism, some studies (Basu, 1997; Givoly and Hayn, 2000; Givoly and Hayn, 2002; Huijgen and Lubberink, 2005; Lobo and Zhou, 2006; Balkrishna, Coulton and Taylor, 2007a; Krishnan, 2007) sought to examine the time-series pattern of earnings conservatism and concluded that earnings conservatism has increased over time (Basu, 1997; Givoly and Hayn, 2000; Givoly and Hayn, 2002; Huijgen and Lubberink, 2005; Lobo and Zhou, 2006; Balkrishna et al., 2007a; Krishnan, 2007). Prior research on earnings conservatism has also identified a number of determinants which influence earnings conservatism (Ball et al., 2000a; Gigler and Hemmer, 2001; Easton and Pae, 2004; Gassen et al., 2006a; O'Connell, 2006; Qiang, 2007a; Lafond and Roychowdhury, 2008). The determinants can be classified into three broad categories: (1) firm characteristics (2) institutional factors and (3) governance structures. In relation to firm characteristics, Easton and Pae (2004) found evidence that change in cash investment provided significant incremental explanatory power for returns over earnings and earnings changes. Similarly, Pae et al. (2005) showed that earnings conservatism was substantially greater in portfolios of firms with lower price-to-book ratios than in portfolios of firms with higher price-to-book ratios. Kwon, Yin and Han (2006), further indicated that distribution of earnings and discretionary accruals between the two groups of firms were consistent with a higher level of accounting conservatism evident in high-tech firms vis-à-vis low-tech firms. In addition, Pae (2007) found that conditional accounting conservatism was attributable mainly to unexpected accruals suggesting that managers exercise discretion over accruals to expedite the recognition of bad news rather than good news. Prior research has concluded that institutional factors such as accounting polices and regulation, legal regimes (i.e. code law versus common law), political influence and cross-listing of firms in different jurisdictions have a significant impact on the level of earnings conservatism reported by firms (Pope and Walker, 1999; Huijgen and Lubberink, 2005; Lara et al., 2005; Brown Jr. et al., 2006; Bushman and Piotroski, 2006). Ball, Kothari and Robin s (2000b) results indicated that common-law accounting income did exhibit greater timeliness than code-law accounting income. Pope and Walker (1999), for example, concluded that the US accounting regime was significantly more conservative than the UK regime, when comparing earnings before extraordinary items. Similarly, Huijgen and Lubberink (2005) found that earnings of UK cross-listed firms (in the US) were significantly more conservative than earnings of UK firms without a US listing. In addition, Lara et al. (2005) reported that in certain institutional contexts (that is, weaker investor protection and less dispersed ownership structures), earnings management drove the measures of conservatism. Finally, Bushman and Piotroski (2006) found that investor protections embodied in corporate law and the 5 P a g e

6 efficiency and impartiality of the judicial system played a significant role in creating incentives for timely loss recognition. Recent studies highlight the link between earnings conservatism and corporate governance structures. Beekes, Pope and Young (2004) found that firms with a higher proportion of outside members are more likely to recognize bad news in earnings. Similarly, Ahmed and Duellman (2007) discovered a negative relationship between the percentage of the inside directors on the board and earnings conservatism. They (Ahmed and Duellman, 2007) also found a positive relationship between the ownership percentage of outside directors and earnings conservatism. Similarly, Lafond and Roychowdhury (2008) concluded that firms with lower managerial ownership report more conservative earnings. Ruddock et al., (2006), meanwhile, stated that the provision of non-audit services is positively associated with a reduction in the extent to which earnings reflect bad news on a more timely basis than good news (i.e., earnings conservatism). Finally, Hamilton, Ruddock, Stokes and Taylor (2005) found a significant increase in the asymmetrically timeliness of economic losses when a firm changes an audit partner. Of various corporate governance mechanisms discussed in the popular press and scholarly research during the past decade, board of directors have been a central focus in debates about how to assure and enhance the quality of financial reporting and corporate accounting. Despite the acknowledged role of the board of director, studies have yet to consider the relationship to earnings conservatism. Research does, however, provide evidence of the linkage between board of directors and earnings quality. Various incentives exist to suggest why a board of directors is motivated to ensure the credibility of the financial reporting process and that quality of earnings is preserved. For example, independent directors on the board of directors have a strong incentive to ensure the sub-committee s roles and responsibilities are fulfilled so as to ensure their (i.e., the independent directors) reputational capital and opportunities for appointment to other boards. As high quality earnings will likely be perceived as a key benchmark of a board of director s success and reputation (and that of its members), this provides strong motivation for the sub-committee to undertake actions that enhance earnings quality. As noted earlier, greater earnings conservatism is thought to enhance earnings quality. Consequently, it follows that a board of directors will actively engage in conservative earnings practices with the aim of improving earnings quality. Despite incentives to engage in greater earnings conservatism, the mere presence of the board of directors does not automatically mean such practices will be undertaken. Rather, as highlighted in the extant literature, the effectiveness of the board of directors will determine whether the subcommittee actively seeks to conserve earnings or not. A more effective board of directors will be better able to mitigate opportunities for corporate management to engage in opportunistic behaviour that can affect earnings quality. Furthermore, a more effective board of directors will have greater ability to override aggressive financial accounting policy choices initiated by corporate management that could promote less conservative earnings results. Finally, if a board of directors is more effective 6 P a g e

7 in its arbitration role, this will aid in the development of more systematic compromises between corporate management and external parties (such as the external auditor). Improved resolution of conflicts, therefore, will likely enhance the acceptance of conservative earnings practices. Based on the above discussion, therefore, the general hypothesis tested is postulated as: GH: Australian publicly listed firms with more effective board of directors are more likely to have higher levels of earnings conservatism. 2.3 Components of Board of Director Effectiveness and Influence on Conservatism There are four main categories of board of director effectiveness determinants are identified as: (1) arrangement (i.e., sub-committee independence, size and duality); (2) resources (i.e., financial expertise, committee experience); (3) authority (i.e., power enshrined in the sub-committee); and (4) diligence (i.e., active meeting of sub-committee). 3 The first two categories relate to structural composition whilst the latter two to operational composition features. Whilst postulated above that overall board of director effectiveness is positively associated with earnings conservatism, different components underlying a board of director s effectiveness could have differing degrees of influence. This study is extended to examine this proposition with, hypotheses developed below in respect to four key components (i.e., independence, financial expertise, prior experience and diligence) frequently cited as central determinants of board of director effectiveness Board of Director Independence Corporate governance advocates, regulators and scholars frequently argue a board of directors with a higher proportion of outside directors is less likely to be compromised in undertaking the subcommittees roles and responsibilities. Furthermore, a more independent board of directors is likely to be better able to constrain opportunistic behavior of corporate management. Empirical findings have generally supported the perception an independent board of directors is more effective in constraining corporate management and improving earnings quality. Van der Zahn and Tower (2004), for example, observed a significant positive relationship between earnings management and board of directors with less than a majority of outside directors. Meanwhile, others have determined board of directors comprising solely of non-related directors had a positive association with the quality of the firm s financial reports. McMullen and Raghunandan (1996) also found that firms with reporting problems were less likely to have board of directors composed solely of outside directors. Similarly, Abbott and Parker (2000b) concluded that firms with more independent directors were less likely to be sanctioned by the SEC for fraudulent or misleading financial reporting compared to firms whose board of directors did not comprise of independent directors. Additionally, it is reported fraudulent firms had 3 There is currently no consensus on a definition of audit committee effectiveness. Rather, a number of determinants have been detailed in the extant literature that researchers propose affect the effectiveness of the audit committee. DeZoort et al.,(2002), for example, suggest that audit committee effectiveness occurs when audit committees comprise qualified members who have the authority and resources to protect stakeholder interests by ensuring reliable financial reporting, strong internal controls and comprehensive risk management practices through diligent oversight efforts. 7 P a g e

8 less independent board of directors than no-fraud industry benchmarks. Overall, prior theoretical and empirical research provides a sound foundation to imply that independent board of director members are more likely to (perhaps) require the recognition of bad news sooner and delay the reporting of good news (i.e., actions that support earnings conservatism) in order to protect their reputational capital, reduce contracting and mitigate litigation costs. Thus, more independent board of directors are likely to support more actively actions promoting earnings conservatism. To test this assertion, the following hypothesis is proposed: H 1 : Australian publicly listed firms with a majority of independent directors on the board of director are more likely to have higher levels of earnings conservatism Board of Director Financial Expertise As new corporate governance regulations continue to expand a board of directors role and responsibilities, there is growing pressure on members to develop greater financial expertise to counter the escalating complexity and sophistication of the financial reporting. Theoretical and applied views have been forwarded in the extant literature suggesting greater financial expertise amongst board of director members enhances effectiveness. McDaniel, Marint and Maines (2002) argue the presence of a financial expert improves the quality of the firm s financial statements. DeZoort, Hermanson and Houston (2003) state financial experts provide greater resolve to support the external auditor during auditor-management disagreements. Abbott, Parker and Peters (2004), meanwhile, argue greater financial expertise is better in preventing occurrences of financial misstatements. Finally, Defond et al., (2005) suggest greater financial expertise enhances the firm s overall internal control. Empirical research has generally supported the notion the board of directors effectiveness is enhanced with the presence of a financial expert (or experts) as a member (e.g., Van der Zahn and Tower, 2004). Therefore, the following hypothesis is proposed to test this assertion: H 2 : Australian publicly listed firms with board of directors comprising members with financial expertise are more likely to have higher levels of earnings conservatism Board of Director Experience Corporate governance experience of board of director members is cited by regulators, corporate governance advocates and scholars as a major factor determining the board of directors effectiveness (Blue Ribbon Committee, 1999). Empirical evidence has supported these views. Dezoort (1998), for example, observed experienced directors made more consistent judgements, had better self-insight and higher technical content levels. He (Dezoort, 1998) concluded this signified improvements in effectiveness. Research has found board of director members with greater corporate governance experience were more likely to support the auditor in an auditor-management conflict, and more likely to address and detect material misstatement. Again, experience is seen to have a positive influence on board of director effectiveness. Finally, Carcello and Neal (2003) found directors who sat on other board of directors (i.e. governance expertise) were more effective in protecting the auditor 8 P a g e

9 from dismissal following the issuance of a going concern report. Based on theoretical arguments and empirical findings, it is expected board of directors with more experienced members will be more effective in ensuring firms adopt appropriate conservative earnings practices relative to firms with less experienced board of director members. The following proposed hypothesis tests this assertion: H 3 : Australian publicly listed firms with board of directors comprising members with prior governance experience are more likely to have higher levels of earnings conservatism Board of Director Diligence It is strongly argued in the extant literature (Abbott et al., 2004; Bedard et al., 2004; Menon and Williams, 1994; Xie, Davidson, and DaDalt, 2003) that an effective board of directors meets regularly; thus, is more capable of ensuring the financial reporting process is functioning properly. A more active board of directors is thought to be able to detect and prevent opportunistic behaviour by management and to ensure the integrity of reported earnings. Past research indicates the board of directors of fraud firms met less often than board of directors in firms not experiencing fraud. Similarly, firms with board of directors meeting at least biannually were less likely to be sanctioned by the SEC for financial reporting problems. Others such as McMullen and Raghunandan (1996), Abbott et al., (2004) and Vafeas (2005) find firms with reporting problems had less frequent meetings. Xie et al., (2003), meanwhile, find the number of board of director meetings is negatively associated with discretionary current accruals implying diligence is an important factor in constraining the management s propensity to manage earnings. Finally, Krishnan and Visvanathan (2007b) show that board of directors meeting more regularly were more likely to detect internal control weaknesses. Prior literature considering board of director diligence literature clearly demonstrates the importance of having sufficient board of director meetings per year and its impact on the financial reporting process. Based on the prior empirical findings, therefore, it is likely more diligence board of directors will be better able to ensure the adoption of conservative earnings practices to ensure greater earnings quality. To formally test this assertion, the following hypothesis is forwarded: H 4 : Australian publicly listed firms with more diligent board of directors (i.e., meet more frequently) are more likely to have higher levels of earnings conservatism. 3. Sample and Method 3.1 Selection and documentation Data for this study is obtained from a number of sources. Data for the earnings conservatism measure is obtained from two different databases. Accounting data is collected from FinAnalysis whilst stock return data is obtained from DataStream. Data for the main independent variable, board of director effectiveness (i.e. AC) comprising four primary sub-components (e.g., board of director independence, financial expertise, experience and diligence), is hand collected the 2008 financial year 9 P a g e

10 annual report of firms included in the sample. 4 The annual reports were obtained from the Annual Reports Collection (Connect 4 Pty Ltd). Where annual reports were not available from the Annual Reports Collection (Connect 4 Pty Ltd) database the documentation was from DatAnalysis or direct from the firm. Analysis involves an examination of a sample of 100 stratified-randomly firms listed on the Australian Stock Exchange (ASX) during the 2008 calendar year. 5 The initial sample comprises all publicly listed firms listed on the ASX as at January 1, Consistent with prior research, financial, banking, insurance and utilities are excluded from the sample (Ball et al., 2000a; Givoly and Hayn, 2000; Goodwin, 2003; Ruddock et al., 2006; Givoly et al., 2007). Firms not continuously listed on the ASX during the observation period (specifically IPO firms and firms de-listed for a period of time and re-listed) are also excluded in order to avoid undue influences of unexpected share price changes. Consistent with Clifford and Evans (1997), foreign firms domiciled outside Australia are also excluded since their (foreign firms domiciled outside Australia) financial statements are not always prepared in accordance with the normal disclosure requirements for other firms listed on the ASX. Firms that have an indication of missing data during the observation period are also excluded (Klein, 2002b) leaving a sample pool of 1,628 firms. From the resulting sample pool of 1,628 firms, 100 are randomly selected using a stratifiedrandom approach which involves stratifying each year into quartiles by market capitalization and randomly selecting a sample of 25 firms within each quartile (Balvers et al., 1990). 6 However, from the final sample of 100 firms, 6 firms are further excluded given incomplete information leaving a final usable sample of 94 firms. Table 1 Panel B presents the industry breakdown of the sample firms. Industrials and materials collectively represent the highest proportion of final sample firms by industry. This representation is proportionally representative of the market as a whole. Thus, each industry contains enough observations to control for the industry effects in the regression. [Insert Table 1 About Here] 3.2 Measurement of Earnings Conservatism 4 In financial (or fiscal) year in Australia runs from July 1 to June 30 of the following calendar year. For ease of administration this study sought to align the financial year as close as possible with the calendar year. Consequently, a firm s annual report is defined to be from the 2008 financial year if the firm s end of financial year is between April 1, 2008 and March 31, Of the final useable sample on nine [9] firms had financial year ending on dates other than June 30, Eight [8] firms had December 31, 2008 year ends and one [1] firm had an August 31, 2008 year end. 5 Results reported in this study are preliminary results for a larger longitudinal study. The longitudinal study covers a five calendar year period (January and December ). The five-year period is selected to minimize any significant extraneous influences on findings as a result of fallout from the Dot.Com Bubble, the introduction of new International Financial Reporting Standards (IFRS) and excessive volatility due to the 2009 Global Financial Crisis. The period for the broader longitudinal study is also selected as it transcends the introduction of key corporate governance reforms in Australia (i.e., CLERP 9 and ASX 2003). Findings from this study may indicate whether recommendations related to audit committees in CLERP 9 and ASX 2003 impact the audit committee effectiveness/earnings conservatism linkage. Due to time constraints the current paper focuses on only a single year. In future versions the full study analysis will be reported. 6 Since one of the major drivers of firm performance is the need to maximize shareholder value, this measure is best reflected by the firm s market capitalization. For this study firms will be the same for each of the calendar years examined. This raises a possible independence issue. However, it is not considered detrimental to the study because: (a) it only applies to the longitudinal OLS regression models to be used and (b) almost all of the past literature (in both accounting and finance fields) using firm-year observations for multivariate testing accept the fact that independence of samples may be of concern but that there is no other parsimonious way to undertake such length-of-time analysis where the changes in selected firm s results are of interest to the researcher/s. 10 P a g e

11 Prior research suggests earnings conservatism can be conceptualized in several different ways. Three dominant views detailed in the literature perceive earnings conservatism as being a function of either: (a) timeliness, (b) persistence or (c) differences in current period accruals and cash flows (Basu, 1997; Ruddock et al., 2006; Watts, 2003). A comprehensive analysis of earnings conservatism and the three major perceptions of this concept such be undertaken to develop a more definitive picture. Such analysis is undertaken in additional work not reported in this current paper due to time constraints. Hence, for purposes of this initial exploratory study analysis focuses solely on the timeliness of conservatism. To measure the timeliness of earnings conservatism the methodology developed by Basu (1997) is used. Equations 1details the basic model underlying Basu s (1997) measure of the timeliness of earnings conservatism: X jt = α 0 + α 1 DR jt + β 0 R jt + β 1 DR jt *R jt + ε jt [1] Where: X jt = Operating profit after tax of firm j deflated by market value of equity (MVE t-1 - Market value of equity of firm j at beginning of the fiscal year t) of firm j at beginning of the fiscal year t; R jt = Buy-and-hold return over the fiscal year t of firm j (i.e., (P t P t-1 )/P t-1 where P t is the price of shares for firm j at the end of the fiscal year t and P t-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j; DR jt = Indicator variable where firm j is scored one (1) if R jt is negative, otherwise firm j is scored zero (0); DR jt *R jt = Two-way interaction between indicator variable where firm j is scored one (1) if R jt is negative, otherwise firm j is scored zero (0) and the buy-and-hold return over the fiscal year t of firm j (i.e., (P t P t-1 )/P t-1 where P t is the price of shares for firm j at the end of the fiscal year t and P t-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j; α k, β k = Coefficients; and ε jt = Error term. Basu s (1997) timeliness model of earnings conservatism (i.e., Equation 1) presumes losses are recognized more quickly than gains so share prices reflect bad news in contemporaneous market losses earlier than good news via market gains Measurement of Board of Director Effectiveness Presently there is no consensus on a precise measure for board of director effectiveness. Following prior work (Beasley and Salterio, 2001; Klein, 2002a, 2002b; Van der Zahn and Tower, 2004), this study develops a composite score for board of director effectiveness based on the subcommittees independence, expertise, experience and diligence. Specifically, for firm j in time period t, a composite score for board of director effectiveness (henceforth denoted BoD jt ) is based on a score of one (1) being awarded for each of the following individual characteristics being met: The board of director of firm j in time t consists of a majority of independent directors; At least one independent board of director member of firm j in time period t is a qualified person with accounting expertise possessing necessary educational qualifications (i.e., degree 11 P a g e

12 in accounting) and professional credentials (i.e., member professional accounting body) and/or work experience as a chief executive officer in a non-for-profit organization 7 ; At least one independent member of the board of director of firm j in time period t has prior experience on the board of director of another firm; and The board of director of firm j met 4 or more times during the time period t. The range of scores for BoD jt, therefore, is zero (0) to four (4). For additional analysis, BoD jt is decomposed into four measures representing each individual component. Specifically, the measure for: (a) board of director independence is denoted as Ind_BoD jt ; (b) board of director expertise is denoted as Expt_BoD jt ; (c) board of director experience is denoted as Exp_BoD jt ; and (d) board of director diligence as Dil_BoD jt. Each individual board of director effectiveness component metric is scored as per the respective criteria outlined in scoring BoD jt. Data to calculate respective board of director effectiveness measures is obtained from annual reports of firms selected in each firm year. The calculation can be represented mathematically in Equation 2 as: BoD jt. = (Ind_BoD jt + Expt_BoD jt + Exp_BoD jt + Dil_BoD jt ) [2] Where: BoD jt = Composite audit committee effectiveness score of firm j in fiscal year t; Ind_BoD jt = Indicator variable that takes the value of 1 if the majority of the board of directors of firm j in time period t are independent directors, and 0 otherwise; Expt_BoD jt = Indicator variable that takes the value of 1 if at least one independent director of the board of directors of firm j in time period t has necessary expertise (based on educational, professional affiliations and/or non-for-profit role) to be financially qualified, and 0 otherwise; Exp_BoD jt = Indicator variable that takes the value of 1 if at least one independent director of the board of directors of firm j in time period t has prior board of director experience, and 0 otherwise; Dig_BoD jt = Indicator variable that takes the value of 1 if the board of directors of firm j in time period t met four [4] or more times during time period t, and 0 otherwise; 3.4 Statistical Analysis To formally test the general hypothesis, Equations 1 is extended to incorporate intercept and slope coefficients for the interactive effects of a board of directors effectiveness. The test model is defined by Equations 3: X jt = α 0 + α 1 DR jt + α 2 BoD jt + α 3 DR jt *BoD jt + β 0 R jt + β 1 R jt *DR jt + β 2 R jt *BoD jt + β 3 R jt *DR jt *BoD jt + ε jt [3] Where: X jt = Operating profit after tax of firm j deflated by market value of equity (MVE t-1 - Market value of equity of firm j at beginning of the fiscal year t) of firm j at beginning of the fiscal year t; DR jt = Indicator variable where firm j is scored one (1) if R jt is negative, otherwise firm j is scored zero (0); BoD jt = Composite board of director effectiveness score of firm j in fiscal year t; DR jt *BoD jt = Two-way interaction between indicator variable where firm j is scored one (1) if R jt is negative, otherwise firm j is scored zero (0), and the composite board of director effectiveness score of firm j in fiscal year t; 7 In order to effective manage the finances of a non-for-profit organization a chief executive officer will need to be financially literate and component with a major understanding of financial accounting and auditing issues. Publicly listed firms may desire individuals with a nonfor-profit background to fill the role of an independent director so as to enhance to concept of independence. 12 P a g e

13 R jt = Buy-and-hold return over the fiscal year t of firm j (i.e., (P t P t-1 )/P t-1 where P t is the price of shares for firm j at the end of the fiscal year t and P t-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j; R jt *DR jt = Two-way interaction between the buy-and-hold return over the fiscal year t of firm j (i.e., (P t P t-1 )/P t-1 where P t is the price of shares for firm j at the end of the fiscal year t and P t- 1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j and indicator variable where firm j is scored one (1) if R jt is negative, otherwise firm j is scored zero (0); R jt *BoD jt = Two-way interaction between the buy-and-hold return over the fiscal year t of firm j (i.e., (P t P t-1 )/P t-1 where P t is the price of shares for firm j at the end of the fiscal year t and P t-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j and the composite board of director effectiveness score of firm j in fiscal year t; R jt *DR jt *BoD jt = Three-way interaction between the buy-and-hold return over the fiscal year t of firm j (i.e., (P t P t-1 )/P t-1 where P t is the price of shares for firm j at the end of the fiscal year t and P t-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j, indicator variable where firm j is scored one (1) if R jt is negative, otherwise firm j is scored zero (0), and the composite board of director effectiveness score of firm j in fiscal year t; α k, β k = Coefficients; and ε jt = Error term. In determining the influence of board of director effectiveness (and individual components) on earnings conservatism, the sign and significance of the coefficients on β 2 and β 3 are considered. If higher board of director effectiveness is associated with firms reporting conservative earnings on a timely basis, then the β 2 and β 3 coefficients in tests of Equation 3 should be positive and significant. Positive and significant β 2 and β 3 coefficients would indicate greater asymmetric timeliness in the recognition of good and bad news. 4. Main Findings 4.1 Descriptive statistics Table 2 contains the descriptive statistics. For the pooled-sample Table 2 results indicate average operating income (OPAT jt ) declined % during the 2008 financial year. Average and median for 2007 and 2008 financial year operating income values (i.e., OPAT jt-1 and OPAT jt ) for firms in the 1 st Quartile and 2 nd Quartile (3 rd Quartile and 4 th Quartile) are positive (negative). Average operating income for the 1 st Quartile and 4 th Quartile decreased year-on-year (i.e., 2007 financial year compared to 2008 financial year) but interesting increased for firms in the 2 nd Quartile and 3 rd Quartile. Declines in operating income can likely be attributed to the tough economic conditions that developed during the 2008 calendar year that culminated in the Global Financial Crisis. 8 8 The roots of the Global Financial Crisis and the associated global recession (though unlike the majority of developed and emerging economies worldwide Australia never entered recession) can be traced to October 2007 though the most severe ramifications (particularly in respect to stock and commodity markets) did not take hold till the 3 rd and 4 th quarters of Economic growth (Gross Domestic Product) was steady during the 3 rd and 4 th quarters of 2007 (i.e., 4.2%) before decline in subsequent quarters in 2008 (i.e., 3.40% 1 st Quarter, 3.00% 2 nd Quarter, 2.40% 3 rd Quarter and 0.70% 4 th Quarter). The decline in operating profits likely reflects the slowing growth of the global and domestic markets during The operating year for the majority of the final useable sample firms is from July 1, 2007 to June 30, 2008; hence, 3 rd Quarter 2007 to 2 nd Quarter Thus, whilst operating income decline on average, the annual results for the majority of firms were derived prior to the true impact of the Global Financial Crisis taking hold. 13 P a g e

14 Consistent with Lara et al. (2009), Table 2 shows that median value of deflated earnings (X jt ) for the pooled-sample is greater than the mean (i.e., compared to ). This indicates earnings for the pooled-sample is negatively skewed. However, when the pooled-sample is partitioned by quartiles, earnings are negatively skewed (median values exceed mean values) for the 1 st Quartile and 4 th Quartile (i.e., largest and smallest firms by market capitalization). Earnings are positively skewed (mean values exceed the median values) for 2 nd Quartile and 3 rd Quartile; this result which is consistent with Ruddock et al. (2006). In line with the decline in average operating income, the average market capitalization of the pooled-sample decline year-on-year (i.e., MarCap jt-1 and MarCap jt ) by %. Declines in market capitalization are across each quartile sub-sample. The decline is highest (least) amongst firms in the 1 st Quartile (2 nd Quartile). Relative to the market, firms of the final useable sample underperformed as indicated by the negative sign on the average RR-All Ord jt value for the pooled-sample. 9 Whilst firms in the 2 nd, 3 rd and 4 th Quartiles by market capitalization underperformed the general market, firms of the 1 st Quartile outperformed the market on average. Overall, 57 firm (or %) of the final useable sample suffered negative market-adjusted 2008 financial year returns. Of firms in the 1 st Quartile only 11 (or %) had negative market-adjusted 2008 financial year returns whilst 18 (or %) of those in the 4 th Quartile had negative market-adjusted 2008 financial year returns. RR-All Ord jt and DR jt results by quartile suggest smaller firms on the ASX were likely to have suffered greater stock declines for the 2008 financial year than larger counterparts. [Insert Table 2 About Here] The average size of the board of directors of the pooled-sample (i.e., 5.470) is relatively (or perhaps slightly lower) than reported in other countries such as the United States, United Kingdom and Singapore. Consistent with prior research in Australia and abroad, the size of the board of directors tends on average to be smaller when the size of the firm declines. Independent directors accounted on average for % of the members of the board of directors of firms in the pooled-sample. Firms in the 1 st Quartile (4 th Quartile) had the highest (lowest) average percentage of independent director representation on the board of directors. In total 50 (or %) firms in the pooled-sample had board of directors comprising a majority of independent directors (see Ind_BoD jt ). Nearly all 1 st Quartile firms had board of directors with a majority of independent directors whilst only eight [8] firms in the 4 th Quartile had a majority. As argued above an independent director is deemed to have financial accounting expertise if possessing necessary accounting education qualifications and professional affiliations, or is (has) been employed as a chief executive officer of a non-for-profit organization. Table 2 results show 9 There is considerable debate in the literature on the appropriate market index to be used in calculating market-adjusted returns. Values reported in Table 2 are based on use of the All Ordinaries Index for purposes of market-adjustment. The All Ordinaries Index is a relatively broad industry based market measure but is generally comprised of larger firms. Returns using alternative market indices to compensate for size and industry biases were also calculated. Sensitivity tests (as reported in Table 3) were performed using the alternative return measures. 14 P a g e