International Journal of Global Business, 5 (1), 17-35, June 2012 17

The Effectiveness of Corporate Governance Mechanisms on Constraining Earning

Management: Literature Review and Proposed Framework

Ebraheem Saleem Salem Alzoubi

PhD Candidate, College of Business, Universiti Utara Malaysia
06010 UUM Sintok, Kedah, Malaysia
E-mail: he03ma@gmail.com
Mohamad Hisyam Selamat
College of Business, Universiti Utara Malaysia
06010 UUM Sintok, Kedah, Malaysia
E-mail: hisyam@uum.edu.my
Abstract
This paper proposes a conceptual framework that investigates the role of board of directors and
audit committee on earning management (EM). To build the conceptual framework, the
background of governance practices and EM theory utilized. It serves as a guide to senior
management to reduce EM through the execution of governance practices. By developing a
deeper understanding of the relationship between corporate governance and EM, senior
management can thus focus their efforts on the practices that ensure the firms ability to establish
a high level of financial reporting quality (FRQ). Evidence from preceding studies suggested that
the boards of directors who are smaller in size, have more independent directors, are equipped
with financial expertise and meet more frequently are effective in their monitoring role. In the
same way, audit committees with more members, sole independence, more financial expertise
and that are more active are suggested to have a higher oversight function. In regard to EM, this
paper views EM as opportunistic earnings. The present study argues that the firms with effective
characteristics of board and audit committee are less likely to allow EM because opportunistic
earning's cause uncertainty about the economic value of a firm.
Keywords: Board of Directors, Audit Committee, Corporate Governance, Earning Management,
Financial Reporting Quality.

Introduction
The issues of both corporate governance and EM have been receiving a tremendous
concern from government, accounting professional bodies auditing as well as the public,
particularly after the latest high-profile corporate collapses. The integrity of financial reporting
system was being questioned due to the failure of the board to oversight its implementation.
DeFond and Francis (2005) claimed that the corporate collapse consequence has renewed the
significance of corporate governance monitoring role. Furthermore, the regulators believe that
good corporate governance is able to improve the ability of boards and their committees to
manage effectively and in the best interest of shareholders, whose trust and confidence is gained
(SOX, 2002).

International Journal of Global Business, 5 (1), 17-35, June 2012 18

In most cases shareholders depend on the ability of a board and its committee to monitor
the independence of the management 1 . Therefore, the responsibility for FRQ is laid on the
effectiveness of board and its committee. Most of prior studies have focused on the role of the
audit committee as the main agent in ensuring the integrity of financial information and dealing
with issues related to an external audit (Abbott & Parker 2000; Chen et al. 2005). However,
given that the board of directors is responsible for appointing and removing the audit
committees members and the external auditors, their role is equally crucial in promoting a
higher FRQ. The Blue Ribbon Committee (BRC, 1999, p. 6-7) reported that: the performance of
audit committees must be founded in the practices and attitudes of the entire board of directors ...
If the board is dysfunctional, the audit committee likely will not be much better. Similarly, a
few studies have indicated that the audit committees effectiveness is associated with the
composition of the entire board of directors (Boo & Sharma, 2008; Cohen et al., 2002; Collier &
Gregory, 1996; Menon & Williams, 1994). Therefore, in this paper, the monitoring roles of
board and audit committee are argued to be paramount to promote a higher level of FRQ.
Specifically, this paper reviews and synthesizes the results of empirical studies of the
relationship between effective board and audit committee in respect of constraining EM. It has
been argued that the firms with effective board and audit committee increase the credibility of
the financial reports, the firms value and able to safeguard them from damaging their
reputations and legal exposure, all of which promotes the shareholders' interests (Carcello et al.,
2002). When market participants lack the ability to directly observe the reported earnings, they
may expect the managers of the firms in a strong monitoring environment to engage less in EM.
Therefore, the present study further argues that the firms that have strong monitoring
mechanisms through effective board of director and audit committee have a greater ability to
constrain opportunistic earnings, hence reducing uncertainty in the reported earnings.
Literature Review
Corporate Governance
The existing studies have indicated that there is no exact definition for corporate
governance (Solomon, 2007) although a number of corporate governance definitions have been
discussed in previous studies (Cadbury, 1992; Donaldson & Preston, 1995; Shleifer & Vishny,
1997; Turnbull, 1997). For example, the Cadbury (1992, p. 15) defined corporate governance as:
a system by which companies are directed and controlled. This definition highlights the main
players roles in an organization that is included shareholders, the board of directors as well as
the auditor. As cited in the Cadbury (1992), the shareholders are responsible for appointing
directors as well auditors and ensuring the suitable governance system. The function of directors
is to govern the firm, whereas the main role of auditors is to provide an independent check on the
financial statements to the shareholders.
Shleifer and Vishny (1997, p. 737) described corporate governance as: dealing with the
ways in which suppliers of finance to corporations assure themselves of getting a return on their
investment. They suggested that the legal protection of investor rights and the ownership
concentration assist in controlling the discretion of management; consequently, the financiers are
1

This referred to the minority shareholders.

International Journal of Global Business, 5 (1), 17-35, June 2012 19

able to get the returns on their investments. Compatible with the Cadbury (1992), that strains
how the firms are directed as well as controlled, Denis (2001, p. 192) stated that: corporate
governance encompasses the set of institutional and market mechanisms that induce selfinterested managers (the controllers) to maximize the value of the residual cash flows of the firm
on behalf of its shareholders (the owners). Otherwise, Solomon (2007, p. 14) considered the
concerns of stakeholder in the corporate governance definition which is perceived as: a system
of checks and balances, both internal and external to companies, which ensures that companies
discharge their accountability to all their stakeholders and act in a socially responsible way in all
areas of their business activity.
These different corporate governance definitions and explanations existed since the authors
viewed the corporate governance from different perspectives in addition to different theoretical
frameworks. For example, the corporate governance definitions that are outlined through
Cadbury (1992), Shleifer and Vishny (1997) and Denis (2001) seemed to agree that corporate
governance is associated with both ownership and control, and that it is aimed at maximizing the
wealth of the shareholders. The definitions are influenced by the agency theory. Alternatively,
the definition of Solomon (2007) is consistent with stakeholder theory, which believes that
besides the maximizing the wealth of the shareholders, social and environmental issues are of
significant importance to the firm. Stakeholder theory admits that individuals that are both inside
and outside a firm (employees, suppliers, customers, publics, governments or other individuals or
groups) affect or be affected by the firm actions. These groups of individuals are referred as
stakeholders (Freeman, 1984). The firms are responsible to carry out the actions that benefit
them and benefit the whole society.
Given that the current study examines the effect of the board of directors and audit committee
roles on FRQ (i.e. EM), for the purpose of the study, corporate governance is seen as a
monitoring system of checks and balances in order to make sure that the shareholders interests
are protected. This view can be articulated properly in the agency theory. Additionally, the focus
of the present study is related to the FRQ rather than on the impact of the firm on the social and
environmental factors; hence, stakeholder theory seems to diverge from this study aim.
Corporate governance mechanisms monitoring role
Fama and Jensen (1983) suggested that the boards of directors are the main decision
makers in the organization and they have the power to compensate the whole decisions that are
made by the top management. Furthermore, they said that, in the process of decision making, the
initiation and implementation should be separated from the ratification and monitoring of the
decisions in order to make sure the efficient monitoring functions2.
Agency theory suggested that, in order to make sure that effective monitoring functions are
in place board of director members should comprise of a representative from outsider members
(non-executive directors) who is independent of management. Vance (1983) added that the nonexecutive directors provide impartial assessment, that is stockholder-oriented, that establish a
good check and balance on the action of top management. Furthermore, the non-executive
2

The initiation and implementation of decisions are known as decision management, while ratification and
monitoring are known as decision control (Jensen & Meckling, 1976, p. 304).

International Journal of Global Business, 5 (1), 17-35, June 2012 20

directors are vital as they possess significant knowledge (capital market, technology, corporate
law) that enables them to complement the insider information and act the same as arbitrators in
any conflict that may happen among the insiders (Fama & Jensen, 1983). In short, the
independent non-executive directors are better at monitoring management because of their
independent and complimentary knowledge characteristics.
The proposition of non-executive directors in agency theory is contradict to that of
stewardship theory principal. Stewardship theory suggested that the manager is acting as a
steward and that their endeavors promote their principals interest (Davis et al., 1997; Donaldson
& Davis, 1991). The managers are enthused through non-financial motivations and inherent
gratification resulting from hard work and a challenging working environment (Donaldson &
Davis, 1991). Donaldson and Davis (1991, p. 51) stated that: the manager far from being an
opportunistic shirker essentially wants to do a good job, to be a good steward of the corporate
assets. With the intention of maximizing the potential of the managers the suitable approach is
to set up an empowering structure (Donaldson & Davis, 1991). Managers are supposed to be
given clear instructions and a higher position in the hierarchy of the organization where they
would have autonomy and authority to make decisions, and they would be enabled to use their
full capacity in achieving the objectives of the organization. From the point of the shareholders
view, the executive directors on boards are preferred than non-executive directors. This is
because they have better knowledge and awareness of existing operations, and they have more
technical expertise and, therefore, they presume a more responsible attitude towards the
organization (Muth & Donaldson, 1998). Thus, the shareholders could anticipate more return
from them than from non-executive directors who are assumed to be less informed about the
organization and to have a self-serving attitude.
Although stewardship theory identified that executive directors are more beneficial than
non-executive directors, this study believes that the board of directors monitoring role, as
described through agency theory, is more applicable to explain EM variations. Agency theory
recognizes the non-executive directors as a monitoring mechanism which is essential to the
higher FRQ promotion. Hung (1998) suggested that the executives task is focused on a strategic
role rather than a monitoring role. In real systems, the agents or stewards are intent on pursuing
their own interests rather than the others interests.
In addition to having the non-executive director on the board and in the audit committee,
empirical evidence as well suggested that the size of a committee, specific knowledge,
experience and a greater frequency of meetings may strengthen both the board and the audit
committee monitoring functions (Carcello et al. 2002; Abbott et al., 2003; Abbott et al. 2004;
Chen & Zhou 2007; Krishnan & Lee 2009; Monks & Minow 2008; Ronen &Yaari 2008). Zahra
and Pearce (1989) claimed that the board of directors efficiency function is dependent on the size
of board and the type of membership, the attributes of the directors, such as their competence and
skills, the establishment of the appropriate committees and the board of directors meeting
(communication between directors, agenda and documentation). Moreover, Walker (2004, p.
158) noted that: the performance of audit committees necessarily depends on the people
involved, their knowledge, skills, critical capacities, skepticism and determination.

International Journal of Global Business, 5 (1), 17-35, June 2012 21

The relationship between corporate governance mechanisms and financial reporting quality
The board of directors is the major player in the firm success. They are responsible for
setting the goals, strategies and values of a firm, in order to align them with the shareholders
interests. Furthermore, they are responsible for the financial statement transparency and fairness.
The companies required the directors to prepare and assume responsibility for the account of the
individual and the firm administration. The company law stated that the directors must not
approve these accounts except they are satisfied that the accounts have given the true and fair
view and have been prepared so to the pertinent framework of financial reporting. These
accounts, having been prepared and approved through the directors, are required to be audited
through an external auditor as they are to be used through the public. As the highest point in the
firm structure hierarchy, the board of directors is accountable for all activities, strategies and
financial performance, including the action of the sub committees of the firm.
Under the main board, there are many subcommittees; one of them is the audit committee.
The audit committee has a direct link with the firm financial performance as well as the services
of the external auditor. Wolnizer (1995) discussed in depth the tasks that the members of the
audit committee expected to do which are as follows:
(1) Accounting and financial reporting: the audit committee reviews financial statements,
accounting policies, fraud, internal control, changes and all significant matters that could affect
the financial statements.
(2) Auditors and auditing: the audit committee provides recommendations for the external
auditors, reviews the scale of audit fees and non-audit fees, writes a letter of engagement,
reviews the audit plan, ensures auditor independence and allocates resources on the internal
audit. In relation to the audit fees, Collier and Gregory (1996) claimed that an effective audit
committee is responsible for ensuring that the audit scope is sufficient, and to some extent, the
audit committee can make sure that the audit fees reduction does not reach the level where it
may potentially jeopardize the audit work quality.
(3) Corporate governance: the audit committee facilitates the relationship between the auditors
and the board of directors, in addition to reviewing and complying with corporate policies,
ethical policies and codes of conduct.
By implementing the above tasks (1 to 3), firms are expected to enhance the financial
statement credibility, objectivity and reliability, improve the management staff accountability,
reduce any opportunistic behavior of management, increase the efficiency and effectiveness of
internal control as well as that of internal and external auditor and strengthen the board of
directors function while helping them to meet their legal responsibilities (Wolnizer, 1995). In
general, the implication is that the audit committee activities could improve the firm corporate
governance and FRQ.
In the same way, Menon and Williams (1994) suggested two potential advantages gained
from establishing the audit committee. Firstly, the independent audit committee may act as an
independent party among the internal auditor and the external auditor. The independent members
of the audit committee help them to provide an impartial assessment, among the function of the
internal auditor and the services of the external auditor, which in turn improves the financial
statement quality and integrity of the firm (Imhoff, 2003). Secondly, the audit committee may

International Journal of Global Business, 5 (1), 17-35, June 2012 22

enhance the efficiency of the board function, mainly when the board has a large number of
directors. Furthermore, The Blue Ribbon Committee (1999, p. 19) agreed that the audit
committee formation can enhance the financial statement credibility and therefore, maintain the
confidence of the investors. They stated that: the Committee believes the audit committee
will be more effective in helping to ensure the transparency and integrity of financial reporting
and, thereby, maintain the investor confidence that makes our securities markets the deepest and
most liquid in the world.
Earnings management
According to Watt and Zimmerman (1990) and Fields et al. (2001), EM may derive from
the accounting choices' flexibility that is given through Generally Accepted Accounting
Principles (GAAP). The GAAP allows the managers to decide the suitable reporting procedures
as well as to make the estimations and assumptions according to the business environment.
Furthermore, with an option on offer, the managers may choose the reporting procedure that
could benefit as well as increase companies wealth (Watt & Zimmerman, 1990). Accordingly,
accounting choices may create the EM problem3. Such problem causes shareholders, investors
and debt holders to be unable to differentiate the firm true economic value since their reports did
not accurately reflect the firms actual performance.
The literature did not offer a single accepted definition of the term EM. One of the most
commonly used definitions is: Earning management occurs when managers use judgment in
financial reporting and in structuring transactions to alter financial reports to either mislead some
stakeholders about the underlying economic performance of the company or to influence
contractual outcomes that depend on reported accounting numbers (Healy & Wahlen, 1999, p.
365). Another common definition is offered by Schipper (1989, p. 92) who observes that: By
earning management I really mean disclosure management in the sense of a purposeful
intervention in the external financial reporting process, with a view to obtaining the private gain
for shareholders or managers. Consistent with this definition and description of earnings this
study views EM as the opportunistic behavior of management4.
Managers engage in opportunistic earnings for many reasons such as for bonus
compensation (Healy, 1985; Gaver at al., 1995; Holthausen et al., 1995), debt-covenant violation
avoidance (Sweeney, 1994; DeFond & Jiambalvo, 1994), earning decrease and loss prevention
(Barth et al., 1999; Bugstahler & Dichev, 1997) and compensating regulatory or political costs
(Cahan, 1992; Han & Wang, 1998; Jones, 1991).

As pointed out by Fields et al. (2001, p. 260), not all accounting choices involve earnings management, and the
term earnings management extends beyond accounting choice, the implications of accounting choice to achieve a
goal are consistent with the idea of earnings management.
4
The present study acknowledges that EM can also be regarded as beneficial information by the market. The
managers may use earnings to communicate private information that could potentially maximize a firms value
(Arya et al. 2003; Louis & Robinson, 2005; Sankar &Subramanyam, 2001; Subramanyam, 1996; Watt &
Zimmerman, 1986). However, since EM is involved a higher degree of managerial judgment, the auditors and
boards of directors safeguard themselves by constraining EM activities. Thus, the present study concentrates on the
negative aspect of EM.

International Journal of Global Business, 5 (1), 17-35, June 2012 23

Agency theory suggested that one way to monitor the behavior of the agent is through the
compensation contract that enables the principal and agent interests to be aligned perfectly
(Jensen & Meckling, 1976). Such contract can be formed between the shareholders and the
managers, like debt-covenants among managers and lenders. Given the compensation contract as
well as debt-covenants is frequently associated with an accounting number, which in turn create
incentives for managers to manipulate earnings (Watt & Zimmerman, 1978).
Healy (1985) posited that managers incline to select income-decreasing accruals as their
bonus plans are binding at the maximum or minimum levels and income-increasing accruals as
the bonus plans are not binding. She argued that, as earnings are very low and cannot meet the
earnings target inside the accounting procedures, the managers have incentives to further
decrease current earnings in terms of differing revenues or accelerating write-offs, and these
approaches are referred to as taking a bath. These actions, on the other hand, did not essentially
influence current bonus award but may assist to meet the future earning target. On the contrary,
Gaver et al. (1995) found that the managers' select income-increasing accruals as the bonus plans
are falling below the lower bound, and vice-versa. They claimed that their results are more
consistent with the income smoothing hypothesis that stated that managers manipulate earnings
in order to decrease the divergence of reported earnings and to make sure that the current
earnings attain the normal or expected earnings' target5. Holthausen et al. (1995) found similar
findings to Healy (1985), but they found no evidence that income-decreasing accruals are related
to lower minimum boundary and claimed that Healys results may be sensitive to the model used
to estimate the discretionary accruals. In summary, these studies concluded that the plan of the
bonus scheme creates managers incentives to manipulate earnings in order to maximize bonus.
Sweeney (1994) found that while the managers of defaulting firms are approaching covenant
violation, they are more likely to report income-increasing accruals to offset their debt
constraints. DeFond and Jiambalvo (1994) provided similar findings, and they concluded that
debt-covenants affect managers accounting decisions in the previous year and throughout the
year of the violation.
Overall, market participants and stakeholders come into a view to reward the firms with
positive or higher earnings more than the firms with negative or lower earnings; and, hence
managers manipulate earnings to meet the expectations. Bugstahler and Dichev (1997) provided
evidence that managers manipulate earnings to avoid earnings decreases and losses. Particularly,
their results on the frequency of distributions in earnings showed that there are low frequencies
of small earnings decreases and small losses but higher frequencies of small increases in earnings
and small positive incomes are unusual. Barth et al. (1999) suggested that the firms with patterns
of increasing earnings are more likely to have large earnings multiples (higher coefficient of
earnings).
In studies related to regulatory or political cost, Cahan (1992) found that the managers
under anti-trust investigation reported income-decreasing accruals throughout investigation
years. Likewise, Jones (1991) said that the managers be liable to report income-decreasing
accruals when applying import relief to obtain import relief benefits such as increases in tariff or
5

Moses (1987, p. 360) defined income smoothing as: an effort to reduce fluctuations in reported earnings.
Researchers generally have agreed that smoothing involves the use of some device to reduce the divergence of
reported earnings from an earnings number that is normal or expected for the firm.

International Journal of Global Business, 5 (1), 17-35, June 2012 24

reductions in quota. Han and Wang (1998) examined opportunistic earnings in two groups of
firms: petroleum refining firms and the crude oil and natural-gas firms during the 1990 Persian
Gulf crisis. The findings suggested that petroleum refining firms use income-decreasing accruals
to mitigate the possibility of adverse political actions.
To summarize, the above motivations EM reflect the opportunistic behavior on the
management part. This evidence suggests that the managers use their discretion in order to
manipulate the reported earnings, and therefore, the monitoring roles of both the board of
directors and the audit committee are required in order to constrain the behavior of the EM.
The Conceptual Framework and Hypotheses Development
As discussed above, this conceptual framework is developed to examine the relationship between
corporate governance practices and EM. The link between governance practices and EM
activities are illustrated in Figure 1. In this conceptual framework, governance practices and EM
activities are independent and dependent variables respectively. The present study therefore
attempts to bridge the gap by providing a basis for a thorough and insightful discernment of the
influence of corporate governance mechanisms on EM activities. Although the causal
relationships among the constructs, as shown in Figure 1 seem to be straightforward, to our
knowledge, the present study is the only one that examines the associations between governance
practices and EM activities. In order to make practical statements about governance practice and
its relation with EM activities, the conceptual framework requires further analysis.

International Journal of Global Business, 5 (1), 17-35, June 2012 25

Board of Directors Characteristics

Size
H1

Independent
H2

Expertise
H3

Meetings

H4

Earning Management

Audit Committee Characteristics

H5

Size
H6

Independent

H7

H8

Expertise

Meetings

Figure 1: Corporate governance mechanisms and earning management conceptual framework

The board of directors effectiveness

Fama and Jensen (1983) suggested that the board of directors is the highest-level of the
control mechanisms in the organization since they possess the ultimate power to compensate the
decisions that are made through the top management. Evidence suggested that several board
characteristics may influence the effectiveness of their monitoring role. These characteristics are:
size, composition of independence non-executive directors, financial expertise and meeting
frequency.
Board size
Board size is believed to be the basic aspect of the effective decision making. Vafeas
(2005) suggested that the board size and its performance had a non-linear relationship. Both too
small and too large of the board size is likely to make it ineffective. Lipton and Lorsch (1992)
recommended that the ideal board size should not exceed eight or nine directors. Jensen (1993)

International Journal of Global Business, 5 (1), 17-35, June 2012 26

claimed that when the board is more than seven or eight members, it is less effective because of
the coordination and process problem, which in turn adds to weak monitoring. Although average
board size is comparatively large, previous studies have shown that small boards are more
effective because the directors can communicate better among them, as well as easy to manage.6
These factors promote a more resourceful conversation. For example, studies of the board size
and corporate performance have indicated that small boards are linked with higher market
values. Yermark (1996) documented a negative relationship between board size and firm value.
Drawing from Yermarks study, Eisenberg et al. (1998) provided a similar conclusion on the
board size and the firm value in a sample of small and mid-size Finnish firms.
Vafeas (2000) uncovered that market participants perceive the content quality of earning
information is higher in the firms with a small board (with a minimum of five members). This is
possibly because of the commitment of every member and the probability of them accepting their
responsibility as a personal obligation. In comparison to a large board, the monitoring
responsibility is divided among members and less responsibility is carried by every member
(Vafeas, 2000). Abbott et al. (2004) suggested that the firms with small board size experience a
lower incidence of restatements because small boards contribute to effective communication and
there are fewer possibilities of the breakdown communication. This suggested that, as the board
members communicate effectively, they reduce the misunderstanding incidence and consequent
errors, and that they are more sensitive to the issues that may influence their shareholders or
investors confidence, particularly concerning the issues of the financial reporting. Thus the
following hypothesis is proposed:
H1: The board size is negatively related to earning management.
Board independence
Non-executive directors are associated with the responsibility to monitor managers and
thus reducing the agency costs that occur from the ownership and control separation in day-today company management (Brennan & McDermott, 2004; Fama, 1980; Fama & Jensen, 1983).
Therefore, higher proportion of the independent non-executive directors on boards is expected to
induce a more effective monitoring function which then leads to more reliable financial
statements. This is because of the incentive for independent board members to develop
reputation as experts in decision making (Fama & Jensen, 1983) and to provide an unbiased
assessment of the management actions (Vance, 1983).
Previous studies indicated that the independent board is an effective monitoring safeguard.
Beasley (1996) suggested that large proportion of non-executive directors on board tend to be
negatively related to fraudulent of financial statement. Likewise, a stream of literature on
independent boards and EM suggested that the firms with a higher percentage of independent
board members encounter a lower EM incidence (Carcello et al., 2002; Davidson et al., 2005;
Klein, 2002; OSullivan, 2000; Peasnell et al., 2005; Xie et al., 2003). To sum up, all of these
studies recognized independent board as facilitating effective monitoring. This leads to the
following hypothesis development:
H2: The board independence is negatively related to earning management.
6

Xie et al., (2003) and Vafeas (2005) reported the average size of board in their samples is 12.48 and 11.6,
respectively.

International Journal of Global Business, 5 (1), 17-35, June 2012 27

Board financial expertise

The board of director knowledge and experience are significant elements in making sure
the effectiveness of board monitoring function. Carcello et al. (2002) suggested that the boards of
directors members who have more experience in terms of higher number of directorships are
more likely to demand high-quality audit work. Further, Chtourou et al. (2001) claimed that the
directors with a higher tenure of board experience are less likely to be associated with EM. Both
studies concluded that higher level of board expertise lead to higher monitoring incentive.
Additionally, as the board of directors is financially literate, they can understand and
address financial statement issues. Xie et al. (2003) found that EM is less likely to occur in firms
that are run by a board of directors which have a corporate and financial background. Similarly,
Agrawal and Chadha (2005) claimed that the probability of earning restatement is lower in firms
whose boards of directors are financially literate. Evidence from auditor independence literature
suggested that the board of directors with financial expertise tend to limit the non-audit fees
(NAF) purchased from auditors because they believe that a provision of NAF compromise
auditor independence (Lee, 2008).
To come to the point, all of the above studies recognized that the boards of directors who
have specific knowledge and experience are useful in monitoring management. The accounting
and financial knowledge are beneficial to boards of directors to understand better financial
statements and financial reporting issues. Thus the following hypothesis is developed:
H3: The board financial expertise is negatively related to earning management.
Board meetings
One of the responsibilities of the director is attending meeting and by doing so they would
have the privilege to vote key decisions (Ronen & Yaari, 2008). Conger et al. (1998) suggested
that more frequent board meetings improve the effectiveness of the board. The meetings are a
key dimension of board operations (Vafeas, 1999) and an indicator of the effort put in by the
directors (Ronen & Yaari, 2008). Active boards that meet more frequently are more likely to
perform their duties in accordance with the interests of the shareholders (Vafeas, 1999) and put
more effort in monitoring the financial reporting integrity.
Vafeas (1999) found that a higher meeting frequency is a reaction to failing performance.
Xie et al. (2003) argued that boards that rarely meet may only have time for signing management
plans and listening to presentations and thus time to focus on issues such as EM will be limited.
This shows that board activity affects performance, and it is an important factor in constraining
EM. Carcello et al. (2002) and Krishnan and Visvanathan (2009) suggested that higher frequency
of board meetings cause higher audit fees, and this is consistent with the argument that when the
boards of directors meet more frequently, they demand a wide audit effort from the auditor,
which improves the process of audit quality. Additionally, Chen et al. (2006) suggested that the
higher frequency of board meetings reduce the possibility of fraud since regular meetings allow
the directors to identify and resolve potential problems, particularly those that are related to the
FRQ. Based on all these findings, this study hypothesizes the following statement:

International Journal of Global Business, 5 (1), 17-35, June 2012 28

H4: The board frequency meeting is negatively related to earning management.

The audit committee effectiveness
The audit committee is one of the committees that is established by the board of directors
and whose major responsibility has to do with financial reporting. Apart from the benefit that is
gained from the audit committee establishment, previous studies suggested that the size,
composition, expertise and meeting frequency of audit committees may impact their monitoring
effectiveness (DeZoort et al., 2002; Walker, 2004).
Audit committee size
It appears that the audit committee size is one of the significant characteristics that
contribute to its effectiveness. If the audit committee size is too small then an insufficient
number of directors to serve the committee in occurring and thus decrease its the monitoring
effectiveness (Vafeas, 2005). This perhaps because small committee is not capable of fulfilling
its duties efficiently as the given assignments is always increasing. Also, when a committee size
is too large, the directors performance may decline because of the coordination and process
problems and hence highlight another reason for weak monitoring (Jensen, 1993; Vafeas, 2005).
The perfect average of the audit committee size is between 3 and 4 members (Abbott et al.,
2004; Vafeas, 2005; Xie et al., 2003). Evidence from the previous suggested that the firms with
large audit committee are more effective in monitoring the management. Yang and Krishnan
(2005) found that quarterly EM is lower for the firms that have large size of audit committee.7
This may suggest that having a sufficient number of audit committee members increases the
efficiency of its monitoring function in terms of financial reporting integrity.
Chen and Zhou (2007) found that the firms with large audit committee sizes are more
concerned about their auditors reputations and assign the Big4 auditors. In brief, the larger the
audit committee size is the more effective financial reporting monitoring is. Thus the following
hypothesis is proposed:
H5: The audit committee size is negatively related to earning management.
Audit committee independence
Agency theory suggested that the independence of a non-executive director is a crucial
quality that contributes to the effectiveness of audit committee monitoring function (Fama &
Jensen, 1983). Some studies suggested that independent audit committees are less likely to be
associated with financial statement fraud (Abbott et al., 2000; Abbott et al., 2004) and more
likely to be associated with lower EM (Bdard et al., 2004; Davidson et al., 2005; Klein, 2002;
Xie et al., 2003) and a lower incidence of earning restatement (Agrawal & Chadha, 2005). This
is because independent audit committee is able to provide unbiased assessment and judgment
and able to monitor management effectively.

Yang and Krishnan (2005) reported the mean, first quartiles, median and third quartile of audit committee size as
3.587, 3, 3 and 4, respectively.

International Journal of Global Business, 5 (1), 17-35, June 2012 29

Furthermore, Carcello and Neal (2000) suggested that the firms with a higher percentage of
independent audit committees are less likely to receive a going-concern audit opinion from the
auditors. Furthermore, Carcello and Neal (2003) suggested that independent audit committees
are more effective in protecting auditors from dismissal following the going-concern audit report
issuance. Abbott and Parker (2000) and Chen et al. (2005) suggested that having a higher
proportion of independent non-executive directors in audit committees increases the tendency to
assign industry-specialist auditors. In summary, all of these studies suggested that independent
audit committees are associated with lower EM because they can be regarded as effective
monitors. Thus the following hypothesis is developed:
H6: The audit committee independence is negatively related to earning management.
Audit committee financial expertise
DeZoort (1998, p.17) argued that the experience of the audit committee members in
accounting, and auditing is essential for adequate understanding of oversight tasks. He suggested
that: audit and internal control evaluation experience makes a difference in audit committee
members performance on an internal control oversight task. Of primary importance, audit
committee members with experience made internal control judgments more like those of experts
(practicing auditors) in the area than did members without experience.
In different words, both the regulatory concern as well as the experimental evidence
suggested that having suitable experience and knowledge, mainly in accounting and auditing, is
likely to improve the performance and judgment of the audit committee. Furthermore, the
evidence from prior empirical studies suggested that the audit committee financial expertise
improves its monitoring ability and in turn increases the FRQ of the firms. Krishnan and
Visvanathan (2008) found that the audit committees can proficiently assess both the nature and
the appropriateness of accounting choices, constrain the accounting policies' aggressiveness and
provide incentives in order to avoid the litigation risk. The findings also suggested that the audit
committees increase the overall monitoring function therefore they are more likely to promote
accounting conservatism than the audit committees with non-accounting or non-financial
expertise, particularly in the environment where the board of directors is strong.
DeFond et al. (2005) found that market participants positively react to the appointment of
the audit committee with financial expertise in accounting, but there is no reaction noted for
audit committees with non-accounting financial expertise 8 . This is because the committee
members with accounting financial expertise improves the oversight function of the audit
committees and consequently provides a credible signal to the investors whom the firms seek to
a higher FRQ. Additionally, DeFond et al. (2005) suggested that positive market reaction is
concentrated on the firms that are relatively strong in corporate governance. Both studies
concluded that the audit committee with financial expertise complements a strong corporate
governance environment through improving the ability of the board to protect the interest of the
shareholder as well as increase the value of the firm.

DeFond et al. (2005) and Krishnan and Visvanathan (2008) measured the audit committee expertise in three ways:
accounting financial experts (directors with experience as certified public accountant, controller or chief accounting
officer), non-accounting financial experts (director with experiences as chief executive officer or president) and
nonfinancial experts (directors who are neither accounting nor non-accounting financial experts).

International Journal of Global Business, 5 (1), 17-35, June 2012 30

It has been suggested that the financial expertise of the audit committee is related with a
higher FRQ (Abbott et al., 2003; Carcello et al., 2002) and fewer possibilities of opportunistic
earnings (Bdard et al., 2004; Xie et al., 2003). The reason for these is the financial knowledge
and experience that improve the oversight function of the audit committee and its ability to ease
effectively the process of the financial reporting. In general, the reviewed empirical evidences
support that the proposition that audit committees with financial expertise create effective
monitoring function. Thus the following hypothesis is proposed:
H7: The audit committee financial expertise is negatively related to earning management.
Audit committee meeting
Previous studies suggested that firms with the higher number of audit committee meetings
experience less financial restatement (Abbott et al., 2004), are less likely to be sanctioned for
fraud as well as aggressive accounting (Abbott et al., 2000; Beasley et al., 2000) and are
associated with lower EM incidence (Xie et al., 2003). These studies suggested that audit
committees that meet regularly during the financial year are associated with effective
monitoring. The more frequent they meet, the more efficient they discharge their oversight
responsibilities.
Krishnan and Visvanathan, (2009) found a positive association between audit committee
meetings and audit fees, suggesting that the firms with higher number of audit committee
meetings demand more assurances and higher quality audit from their auditors. In order to
provide more assurances and higher quality of external audit, the auditors may need to perform
additional audit work in terms of enlarging the audit scope and increasing the audit testing levels,
which results in both higher audit fees and higher audit quality. As a result, the higher the
frequency of an audit committee meeting is the more effective monitoring function is. This leads
to the following hypothesis:
H8: The audit committee frequency meeting is negatively related to earning management.

Summary and Conclusion

Agency theory assumed that principals and agents have divergent interests and
consequently, are likely to contribute to agency conflicts that include the EM phenomenon. To
align these interests, agency theory recognizes board of directors and audit committee
monitoring roles as playing a key role in mitigation agent-principal conflict.
Evidence from preceding studies suggested that the boards of directors who are smaller in
size, have more independent directors, are equipped with financial expertise and meet more
frequently are effective in their monitoring role. In the same way, audit committees with more
members, sole independence, more financial expertise and that are more active are suggested to
have a higher oversight function. In regard to EM, this paper views EM as opportunistic
earnings. This study argues that the firms with effective characteristics of board and audit
committee are less likely to allow EM because opportunistic earning's cause uncertainty about
the economic value of a firm.

International Journal of Global Business, 5 (1), 17-35, June 2012 31

The initial study on the conceptual framework, which is to examine the link between
corporate practices and the FRQ, has led to further studies on the two mechanisms of corporate
practices, which are known to be important attributes to the FRQ. As for improvements, further
surveys and research should be done using the multivariate analysis to test, validate and enhance
the framework. Currently, the data collect from industrial organization annual report in Jordan is
being designed, in order to confirm the proposed conceptual framework shown in Figure 1, and
its propositions listed above. The results obtained will be reported in a future paper.

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