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Audit Committees and Earnings Management – Evidence from the German Two-Tier Board System

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Abstract

This study investigates whether audit committees of German firms and their characteristics are related to earnings management. This issue is of particular interest, as it reveals the effectiveness of voluntarily established audit committees in a two-tier board system. In contrast, most prior research focuses on the characteristics of mandatory audit committees in one-tier board systems. We use a sample from German listed firms between 2005 and 2009, and accrual-based earnings management serves as a proxy for audit committee effectiveness. The results suggest that the existence of an audit committee is related to a lower degree of earnings management. Using a differences-in-differences approach, we also provide evidence that the level of earnings management decreases after the formation of an audit committee. Moreover, the results show that the participation of financial experts in audit committees and the increase in audit committee meetings are associated with less earnings management, i. e. these characteristics seem to enhance the effectiveness of audit committees. With respect to meeting frequency, 4–5 meetings per year seem to represent an effective number of meetings in order to reduce the level of earnings management.

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Notes

  1. Management incentives to engage in such opportunistic reporting stem, for example from performance-related compensation arrangements, achieving earnings targets (e. g., reporting of yearly earnings increases, beating analyst forecasts, loss avoidance), or enhancing management reputation.

  2. Following e. g. Lück (1990), Lück (1999) and Koprivica (2009), this aspect is substantial in the German two-tier board system.

  3. Due to broad disclosure requirements in the U.S. these studies are based on a much higher accessibility level of audit committee data compared to Germany.

  4. The supervisory board has a superior position and is entitled to withdraw authorities or overrule committee decisions (Paefgen 1982; Rössler 2001).

  5. These firms are subject to different financial reporting requirements that lead to a different structure of balance sheets and accruals, and thus reduce their comparability with other sample firms.

  6. First, these firms often do not have the relevant financial statement data. Second, the data could result in extreme outliers. Third, Collins and Hribar (2002) show that estimating accruals is problematic in this case.

  7. See the empirical results of e. g. Dechow et al. (1995), Kang and Sivaramakrishnan (1995), Peasnell et al. (2000), Jones et al. (2008), which attest this model better specification and greater power to detect earnings management than the original and the modified Jones model.

  8. The financial expertise of the audit committee has to be disclosed as part of the GCGC declaration. However, due to a lack of definition of financial expertise, firms have a broad scope in defining financial expertise and might avoid negative declarations. Therefore, information derived from the GCGC declaration is not sufficiently reliable. Most of the empirical studies focus directly on the committee members’ specific knowledge of financial accounting in defining a financial expert. Some of these studies extend the definition of expertise on management expertise, to specific knowledge in auditing or juridical knowhow.

  9. In a similar way, Velte and Stiglbauer (2011) used survey and internet research with respect to curriculum vitae of supervisory board members to gather data on financial expertise.

  10. We conduct the Hausman test, using the residuals of the first-stage regression as an additional control variable in the original one-stage regression model. The results indicate that there are endogeneity issues, as the coefficient of this control variable is significant.

  11. This procedure is also recommended by Larcker and Rusticus (2007); Tucker (2010) and Lennox et al. (2012), who highlight problems based on selection models and derive suggestions for implementing these models.

  12. We only choose firms that entirely have an audit committee as control firms to better account for potential self-selection issues.

  13. The range of ±30% size difference is used in several matched sample approaches. However, matching only within a range of ±30% results in several suitable firms, which leaves scope of action to choose the “right” one. To overcome this problem, some studies choose firms randomly out of the pool of potentially suitable ones (Abbott 2000; Beasley 1996). Instead, following the studies of Myers et al. (2007) and Louis (2004), we use an additional criterion to select the control firms.

  14. While Jones-based (1991) models are empirically derived, the Dechow/Dichev model is based on an analytical fundament.

  15. See the empirical results of Ernstberger et al. (2016) who support empirical evidence for this argumentation with regard to disclosing mandatory quarterly financial reporting.

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  1. Fachbereich 1, Rechnungswesen, Controlling und Wirtschaftsprüfung, Technische Universität Darmstadt, Hochschulstraße 1, 64289, Darmstadt, Germany

    Benjamin T. Albersmann & Daniela Hohenfels

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Albersmann, B.T., Hohenfels, D. Audit Committees and Earnings Management – Evidence from the German Two-Tier Board System. Schmalenbach Bus Rev 18, 147–178 (2017). https://doi.org/10.1007/s41464-017-0028-9

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