Personal relationships established between the directors and the audit firm/partner may be associated with the reported earnings of linked companies. Agency theory identifies the importance of incentives and self-interest in organisational thinking and assumes that “much of organizational life, whether we like it or not, is based on self-interest” (Perrow, 1986; Eisenhardt, 1989, p. 64). If both the directors and auditors are assumed to be self-interested maximisers" , the manipulation of earnings in
21 Marnet (2004) argues that “the subjective nature of accounting and the tight relationships between auditing firms and their clients is particularly visible in the dealings of the individual auditing partner and the unconscious biases of the auditor, impartiality is difficult to achieve, some would say impossible, as all individuals are biased towards their own interests or prejudices” (p. 274).
the director-audit finn/partner linked companies is likely to be facilitated by appointing a common audit firm/partner for the linked companies. The motivation for directors to manage earnings may be to show a better financial result for linked companies compared to non-linked companies and to signal their credibility as directors of more than one company. They may pressure the auditor to accept managed earnings by offering financial and/or non-financial incentives. Furthermore, in director-audit firm/partner interlocking relationships, the auditor may identify closely with the management and may not exhibit sufficient professional scepticism. As a results, management may be able to take advantage of the auditor’s/partner’s conflict by making a personal appeal for compassion and support (Arel et al., 2005).
Additionally, if the auditor is dependent on the client for a substantial portion of their income, the auditor may be more willing to agree with management’s representations and inteipretations of accounting matters (Firth, 1997a). In director- audit firm/partner interlocking, the auditor may be more dependent on the revenue (audit fees and APNAS fees) from the linked companies compared to non-linked companies.23 This dependency may increase the auditor’s incentive to give in to client pressure, including pressure to allow earnings management. Magee and Tseng (1990) and DeAngelo (1981a) argue that audit quality could be impaired when significant economic rents exist for the auditor’s engagement with a client. Kinney and Libby (2002) argues that a strong economic bond between the auditor and the client will
22 Researchers argue that earnings management may be beneficial because it improves the information value of earnings by conveying private information to the stockholders and the public (Jiraporn et. al.,
2006). Jiraporn et. al. (2006) also posits that the scandals at Enron, WorldCom and elsewhere have generated a public perception that earnings management is utilised opportunistically by firm managers for their own private benefit rather than for the benefit of shareholders. Thus, the directors/management may be motivated to manage earnings to show a better financial result to the users.
23 Earlier in this thesis it is argued that the auditor of linked companies may have more clients from a family of linked companies and earn more revenue because the directors tend to choose a common auditor for their linked companies (Jubb and Houghton, 1999).
reduce the quality of reported earnings through auditors’ reduced willingness to resist client-induced biases in reported accounting information.
Alternatively, Van Der Zahn and Tower (2004) finds that the presence of independent directors serving simultaneously on a substantial number of boards is effective at constraining earnings management. Prior studies (e.g., Beasley, 1996; Dechow et al., 1996; Klein, 2002; Xie et al., 2003; Peasnell et al., 2005; Mather and Ramsay, 2006) find that outside directors are associated with reduced earnings manipulation, fraud or earnings management. Interlocking associations between directors and audit firm/partner may minimise earnings management due to their commitment as agents of shareholders to monitoring roles and their greater financial and non-financial stakes in linked companies compared to non-linked companies.
The above arguments indicate that the association between the number of director interlocks, director-audit finn/partner interlocks and the absolute value of discretionary accruals may be positive or negative and that is why the following hypotheses are presented as non-directional:
H4a: Director interlocking is associated with the absolute value o f discretionary accruals after controlling fo r factors likely to be associated with discretionary accruals.
H4b: Director-audit firm interlocking is associated with the absolute value o f discretionary accruals after controlling fo r factors likely to be associated with discretionary accruals.
H4c: Director-audit partner interlocking is associated with the absolute value o f discretionary accruals after controlling fo r factors likely to be associated with discretionary accruals.
2.2.4.2 Audit committee member interlocking, audit committee member-audit
firm/partner interlocking and the absolute value o f discretionary accruals
An active audit committee may be an important monitoring mechanism for improving the accountability of management and the quality of financial reports by minimising earnings management (Xie et a!., 2003; Bradbury et ah, 2004). Audit committee members sitting on more than one audit committee across other companies may minimise earnings management because audit committee members who sit on more than one audit committee may have more experience and may be in the best position to serve as active overseers of the financial reporting process and have the ability to withstand pressure from management to manipulate earnings (Klein, 2002; Baxter, 2005).
Prior studies report a negative relationship between effective audit committees and earnings management (Klein, 2002). This may also be the case in the presence of audit committee member interlocking and audit committee member-audit firm/partner interlocking because experienced and financially literate individuals are normally appointed to audit committees and they may be more effective at preventing or at least minimising earnings management. Serving on several boards gives audit committee members additional experience and this can enhance their effectiveness in applying this experience to limiting earnings manipulations (Song and Windram, 2004). Furthermore, the external auditor and audit committee members have similar incentives, such as minimising legal liability and desire for a good reputation and therefore similar
incentives to issue high-quality financial reports and these features help to mitigate the mechanism of earnings management (Jenkins, 2002). Audit committee members and the audit firm/partner who serve several linked companies may have more to lose in respect of their reputation if they compromise audit quality. If both parties perform their duties to maximise shareholder interests and to protect their own reputations, their links could improve audit quality by preventing or constraining earnings management
Prior studies relating to audit committees and earnings management use different characteristics of audit committee members to examine their association with discretionary accruals. Klein (2002) reports that audit committee independence is negatively associated with the absolute value of discretionary accruals. Using Korean data, Choi et al. (2004) demonstrates that the independence and competency of the audit committee are associated with earnings management. Xie et al. (2003) finds that audit committee members with corporate or financial backgrounds are associated with smaller discretionary accruals. Their study reports that audit committee activity and members’ financial sophistication may be important factors in constraining the ability of managers to engage in earnings management. Baxter and Cotter (2008) finds higher earnings quality in companies with a greater proportion of qualified accountants on their audit committees. When audit committee members work together with a common audit firm/partner across other companies, they may be more cautious about their reputation, performance and job security, which may motivate them to minimise or constrain earnings management by the linked companies’ management.
Alternatively, an audit committee member who sits on more than one audit committee may not be a good monitor of earnings management issues due to time constraints and direct and indirect benefits. Wright (1996) reports that a direct financial interest (such as stock ownership) by audit committee members is positively associated
with earnings management. Audit committee members have more interests in linked companies compared to non-linked companies due to their large stake and involvement in other companies. Auditors also may ignore the earnings management issue due to their close relationships with management and their large stake in linked companies.
The above arguments indicate that the association between the number of audit committee member interlocks, audit committee member-audit firm/partner interlocks and the absolute value of discretionary accruals may be positive or negative and that is why the following hypotheses are presented as non-directional:
H4d: Audit committee member interlocking is associated with the absolute value o f
discretionary accruals after controlling fo r factors likely to be associated with discretionary accruals.
H4e: Audit committee member-audit firm interlocking is associated with the absolute
value o f discretionary accruals after controlling fo r factors likely to be associated with discretionary accruals.
H4f: Audit committee member-audit partner interlocking is associated with the absolute value o f discretionary accruals after controlling fo r factors likely to be associated with discretionary accruals.