Auditor independence, audit committee effectiveness, and earnings management

I examine the joint association between earnings management and two monitoring mechanisms—audit committee effectiveness and auditor independence. Because of concerns regarding the lack of oversight by audit committees and the effect of non-audit services on the quality of financial reporting, the Securities and Exchange Commission (SEC) initiated audit committee regulations and revised auditor independence rules. Using data collected from the 2001 proxy statements of a sample of Fortune 1000 firms, I present evidence that effective audit committees and independent auditors jointly diminish earnings management. I find that effective audit committees and more independent auditors both mitigate income-increasing earnings management, and they both appear to induce a conservative bias on income-decreasing earnings management. These results are contrary to those found in prior studies which indicate that both monitoring mechanisms drive earnings management toward zero in both the income-increasing and income-decreasing sides of the distribution. My findings have implications for future research of how various monitoring mechanisms mitigate earnings management. Specifically, my work suggests that future research should consider not only the magnitude but also the direction of performance adjusted abnormal accruals as a surrogate for earnings management. Moreover, when investigating the role of audit committees and external auditors in financial reporting issues, both monitoring mechanisms must be considered jointly. Lastly, the innovations of the SEC with regard to audit committees and auditor independence has positively affected the quality of financial reporting. However, my results indicate that additional improvement may be obtained through standardization of regulations and enforcement.