1

Accrual Management to Meet Earnings Targets:

U.K. Evidence Pre- and Post-Cadbury*

K.V. Peasnell, P.F. Pope and S. Young

Lancaster University

Draft: October 1999

Key Words: Earnings management; non-executive directors; abnormal accruals;

Cadbury Report.

Data Availability: Data are available from public sources.

JEL Classification: M41, G34

* This paper has benefited from the helpful comments of Andrew Stark, participants at the 1998Financial Accounting and Auditing Research Conference, two anonymous reviewers and TrevorHopper. Financial support was provided by the Research Board of the Institute of CharteredAccountants in England and Wales, the Leverhulme Trust, and the Economic and Social ResearchCouncil. Correspondence to: Steven Young, I.C.R.A., The Management School, Lancaster University,Lancaster, LA1 4YX, U.K., Tel: (+44)-1524-593978, Fax: (+44)-1524-594334, E-mail:s.young@lancaster.ac.uk

2

Accrual Management to Meet Earnings Targets:

U.K. Evidence Pre- and Post-Cadbury

Abstract

Central to both the Cadbury Committee’s initial remit and its subsequent

recommendations is the view that director integrity and board effectiveness play key

roles in ensuring the quality and reliability of published financial statements. Using a

constant sample, this paper tests whether the association between board composition

and earnings management activity differs between the pre- and post-Cadbury periods.

Earnings management is measured by the use of income-increasing abnormal accruals

when unmanaged earnings undershoot target earnings. Results provide evidence of

accrual management to meet earnings targets in both periods. However, while we find

no evidence of an association between the degree of accrual management and the

composition of the board of directors in the pre-Cadbury period, results for the post-

Cadbury period indicate less income-increasing accrual management to avoid earnings

losses or earnings declines when the proportion of non-executive directors is high.

These results are consistent with the view that appropriately structured boards are

discharging their financial reporting duties more effectively post-Cadbury.

1

Accrual Management to Meet Earnings Targets:

U.K. Evidence Pre- and Post-Cadbury

1. INTRODUCTION

Boards of directors are legally charged with monitoring management on behalf

of shareholders. Traditionally, however, boards of large U.K. companies were

considered relatively passive entities, often dominated by the very managers whom

they were supposed to monitor. This raised concerns in some quarters about a possible

lack of managerial accountability. The Report of the Committee on the Financial

Aspects of Corporate Governance (1992) (hereinafter, Cadbury Report) focused

attention on the board’s monitoring responsibilities and highlighted the special

contribution that non-executive directors (NEDs) can make to this process. Subsequent

efforts by U.K. listed firms to comply with the recommendations contained in the

Cadbury Report have increased the demand for NEDs (Peasnell et al., 1998; Cadbury

Compliance Report, 1995). Equally important, the publicity and public debate

generated by the Cadbury Report has clarified the monitoring responsibilities of

NEDs, particularly with respect to financial reporting. Peasnell et al. (1999a) present

evidence supporting the view that NEDs help to constrain accrual management to

meet earnings targets post-Cadbury. This paper extends Peasnell et al.’s results by

testing (a) whether a similar relation holds for the pre-Cadbury period and (b) whether

the increased emphasis on managerial accountability in the post-Cadbury period is

associated with a significant improvement in the extent to which NEDs currently

discharge their financial reporting duties.

The Cadbury Committee was established in May 1991 by the Financial

Reporting Council, the London Stock Exchange and the accountancy profession to

2

review the aspects of corporate governance specifically related to financial reporting

and accountability. A primary stimulus underlying its formation was the declining

confidence in U.K. financial reporting resulting (in part) from a series of unexpected

business failures and high profile financial scandals that occurred during the late

1980s and early 1990s. The manipulation of accounting numbers was perceived to be

widespread (Griffiths, 1986). In response, the Committee issued a voluntary Code of

Best Practice aimed at promoting higher standards of corporate behaviour. A central

theme in the Cadbury Report is the link between internal governance procedures and

the financial reporting process. Pivotal to the Code of Best Practice is the role of the

board, and in particular its NED component, in helping to ensure the quality and

integrity of accounting information.1

The new emphasis placed on the role of NEDs has not met with universal

acclaim. In particular, some elements in the business community are dissatisfied with

the increased emphasis on the board’s monitoring duties and question the benefits (if

any) associated with the “corporate watchdog” view of NEDs exceed the costs. To

date, however, we are unaware of any empirical research that seeks to explore whether

the level of monitoring by NEDs has changed significantly following the publication

of the Cadbury Report. This paper seeks to make good this deficiency by examining

the links between board composition and earnings management activity in the period

spanning the Cadbury Report’s issuance.

Measuring accounting manipulations is fraught with difficulty. We follow

prior research by using abnormal working capital accruals to proxy for earnings

management. Board composition is defined as the ratio of NEDs to total board size.

Results for the post-Cadbury period (1994-1995) confirm those reported by Peasnell et

al. (1999a) who show that when the proportion of NEDs is high, managers are less

3

likely to make income-increasing accruals to avoid reporting earnings losses or

earnings declines. In contrast, our results provide no evidence of an association

between income-increasing abnormal accruals and the proportion of NEDs in the pre-

Cadbury period (1990-1991). Our evidence is consistent with the view that

appropriately structured boards are discharging their financial reporting duties more

effectively post-Cadbury.

It should be recognised, however, that these tests do not directly demonstrate

that the structural break in the association between abnormal accruals and board

composition was caused by the Cadbury Report’s recommendations and the associated

pressure for increased managerial accountability. Consequently, the second stage in

our analysis involves examining two competing explanations for our findings. First,

we test whether a change in the earnings management instrument resulting from the

introduction of FRS3 is driving our findings – in particular, whether firms appear to

have used extraordinary items to manage reported results before 1993 and

discretionary accruals afterwards. Secondly, we test whether temporal variation in the

stimulus for earnings management can explain our findings – that is to say, whether

the assumed desire to meet earnings targets changed sufficiently over time to account

for our results. We find that neither explanation can account for the observed

structural break. These tests provide some assurance that our findings are not being

driven by confounding events. Our results suggest that NEDs now play a more

prominent role in constraining earnings management. However, it still remains an

open question whether this can be directly attributed to the changes brought about by

the Cadbury Report.

The remainder of the paper is organised as follows. The following section

discusses the role and evolution of the board of directors in the U.K. and develops the

4

prediction of improved board monitoring in the post-Cadbury period. Section 3

presents details of our research design and sampling procedure, while section 4 reports

evidence of a change in the relationship between earnings management and board

composition over the period 1990-1995. Section 5 presents and tests two competing

explanations for our findings. Conclusions appear in section 6.

2. MOTIVATION AND HYPOTHESIS DEVELOPMENT

Boards and Monitoring

Boards of directors perform the dual roles of decision ratification and decision

monitoring (Fama and Jensen 1983, pp. 311). To facilitate effective monitoring,

boards include outside members who play no direct role in the management of the

company. Proponents of the boards-as-monitors view believe that NEDs are central to

the effective resolution of agency problems between managers and shareholders (e.g.,

Fama and Jensen, 1983, pp.311). Until recently, however, the boards of large U.K.

companies were typically composed of senior managers selected from within the

organisation. For example, over 20% of companies in the Times 1000 had no NEDs in

1982 (Bank of England, 1983). As a result, the arms-length relationship implied in the

board’s monitoring role was severely compromised.

The Cadbury Report was published in December 1992 and contains a Code of

Best Practice designed to serve as the benchmark against which good governance can

be assessed. The Code recommends, inter alia, that all firms create an audit committee

with at least three members and consisting exclusively of NEDs. While the Code does

not explicitly specify a minimum number of non-executive board members, the

recommendation relating to audit committees means that firms must have at least three

NEDs in order to report full compliance. Through the recommendations contained in

5

the Code of Best Practice, the Cadbury Report (1992) helped raise expectations

concerning the governance role of the board of directors and enhanced the profile of

NEDs in relation to the board’s monitoring duties. More generally, the Report acted as

a catalyst for a wider debate on managerial accountability and the importance of

effective corporate governance.

The recommendations contained in the Cadbury Report do not have the force

of law. Compliance with the Code is voluntary and as a result companies remain free

to choose their own board composition. However, the London Stock Exchange

adopted as part of its listing rules the requirement for all U.K.-incorporated listed

firms to include a statement of compliance with the Code in their annual report and

accounts for fiscal years ending on or after 30 June 1993.. In the event that a firm does

not fully comply, details of (and reasons for) the non-compliance must be disclosed,

thereby making non-compliance a potentially costly action.

The recommendations contained in the Cadbury Report, together with the

increased concern with corporate governance matters more generally, have resulted in

a substantial re-organisation of U.K. boards (Peasnell et al. 1998). For example, to

ensure that the direction and control of the organisation is firmly in the hands of the

board, most companies now have a formal schedule identifying matters reserved to the

board for decision (Cadbury Compliance Statement 1995, pp.24). As a result, many

boards now operate in a different mode than they did a few short years ago and a view

is emerging that U.K. boards have begun to take their monitoring responsibilities more

seriously than was the case in the past.2 However, opinion on the monitoring role of

the board and the watchdog view of NEDs remains sharply divided. On the one hand,

many shareholder groups and governance specialists view the monitoring role ascribed

to NEDs in the Cadbury Report as one of its most significant contributions and believe

6

that it has led to an improvement in the calibre and effectiveness of U.K. boards.3 In

contrast, others view the increased emphasis on NEDs for monitoring and control

purposes as either irrelevant, excessively costly, or as a threat to board unity.4 In

addition, many critics maintain that NEDs perform little or no real monitoring role

because they lack the necessary independence, time, expertise, and information to

challenge management effectively (Gilson and Kraakman, 1991, pp.875; Patton and

Baker, 1987, pp.11). In the absence of a clear theoretical basis for distinguishing

between these competing views, the monitoring role of NEDs and the impact of the

Cadbury Report on this role are empirical issues on which this paper aims to provide

some evidence.

Financial Reporting

The quality of financial reporting lay at the heart of the Cadbury Report. While

company law holds boards responsible for the financial reporting process, the extent to

which boards effectively discharged these responsibilities in the pre-Cadbury period

was questionable (Cadbury Report, 1992). As an indication of the relative low weight

that many boards attached to financial reporting matters, only 38% of companies

surveyed by the Bank of England in 1988 had established an audit committee (Bank of

England, 1988). In contrast, this figure had risen to almost 92% by 1995, the majority

of which had written terms of reference outlining their membership, authority and

duties (Cadbury Compliance Report, 1995).

A central issue affecting the quality of financial statements is the extent to

which managers manipulate reported earnings numbers (Cadbury Report, 1992,

pp.14). Earnings are widely used by shareholders in contracting with senior managers,

both directly as a basis for awarding bonuses and indirectly as reference points for

triggering the award of executive stock options. Therefore, adverse earnings outcomes

7

can have unfavorable wealth consequences for senior management. Moreover,

Weisbach (1988) provides evidence that senior management turnover is associated

with poor reported performance. These factors create potentially strong incentives for

managers to manipulate reported earnings for opportunistic reasons (Watts and

Zimmerman, 1986).

The board’s legal responsibility for the content and presentation of financial

statements, coupled with the specialised monitoring role ascribed to non-executives,

raises the expectation that the extent of earnings management activity will be

negatively related to the presence of NEDs on the board. Of course, this assumes that

NEDs (a) posses sufficient incentives to monitor the financial reporting process and

(b) are capable of identifying cases of earnings management. Economic arguments

exist that support the first assumption. For example, while NEDs face potentially

significant costs from earnings management such as loss of reputation as effective

monitors (Fama, 1980; Fama and Jensen, 1983), the benefits are expected to accrue

primarily to executive directors in the form of increased current period compensation

(Healy, 1985; Holthausen et al., 1995) and reduced likelihood of dismissal (Weisbach,

1988). In the absence of any significant benefits accruing to NEDs from earnings

management, the associated costs are predicted to provide them with powerful

incentives to monitor the financial reporting process. As for the assumed ability of

NEDs to identify cases of earnings management, several factors suggest that this

condition will be met. First, Peasnell et al. (1999b) report that non-executives in the

U.K. often have a professional accounting background. Second, NEDs frequently hold

senior management positions in other large firms and as such are likely to be relatively

familiar with financial reporting issues, even if they do not actually possess a formal

accounting qualification. Finally, the firm’s auditor has a role to play in identifying

8

unusual or questionable accruals and bringing them to the attention of NEDs through

communications with the board and the audit committee.

Consistent with NEDs possessing both the necessary incentives and ability to

monitor the quality of published financial statements, Beasley (1996) and Dechow et

al. (1996) find that U.S. firms subject to fraud allegations and SEC Enforcement

Actions are characterised by a lower proportion of non-executive board members.

Similarly, Peasnell et al. (1999a) present evidence of the predicted negative

association between earnings management activity and the proportion of non-

executive board members for a sample of U.K. firms in the post-Cadbury period.5

However, while Peasnell et al. (1999a) assess the monitoring role of NEDs in the

context of the U.K. financial reporting process, that study does not examine how this

association has evolved over time. All else equal, if the Cadbury Report (1992) and

the ensuing governance debate have helped improve the effectiveness with which

boards discharge their financial reporting responsibilities, one might expect the

association between board composition and income-increasing earnings management

to have become more pronounced in the post-Cadbury period. We therefore test the

following hypothesis:

H1: Ceteris paribus, the negative association between income-increasing earnings

management and the proportion of non-executive board members is more

pronounced in the post-Cadbury period.

3. METHODOLOGY

Earnings Management

Earnings management instruments can be divided into two types: real

operating decisions such as asset sales (Black et al., 1998; Bartov, 1993) and changes

9

in R&D expenditure (Bushee, 1998; Bange and DeBondt, 1998), and pure financial

reporting decisions such as accounting method changes (Watts and Zimmerman, 1986)

and accrual choices (McNichols and Wilson, 1988). Senior managers face costs

associated with both types of instrument. The primary cost of using real operating

decisions to manage earnings is that it can reduce shareholder value. The cost of

accounting manipulations is that their effects must reverse sometime in the future. In

other words, boosting earnings in one period must reduce subsequent earnings. We

conjecture that since the costs of reversals are likely to be less than the costs of

resorting to sub-optimal operating decisions to boost reported performance, managers

will generally prefer to use pure financial reporting decisions to manage earnings

(Peasnell, 1998). This is particularly likely to apply in those situations where the goal

is to temporarily boost reported profit. We therefore focus in this study on earnings

management in the form of accounting manipulations.

We follow recent work on earnings management by measuring accounting

manipulation using aggregate accounting accruals. Accruals summarise in a single

measure the net effect of numerous recognition and measurement decisions, thereby

capturing the portfolio nature of income determination (Watts and Zimmerman, 1990,

pp.138). However, unlike most prior studies that use total accruals, defined as working

capital accruals plus depreciation, we focus solely on the working capital element.

Using working capital accruals to measure earnings management is potentially more

appealing than using total accruals for several reasons. First, Young (1999)

demonstrates that the modified-Jones model induces systematic measurement error in

the resulting abnormal accruals estimate when accruals are measured inclusive of

depreciation. Secondly, there are strong reasons to believe that working capital

manipulations will be more opaque than non-current account manipulations. Working

10

capital accruals include such judgmental items as provisions for doubtful debts,

warranties and inventory obsolescence which prior research has shown are used to

manage earnings (e.g., McNichols and Wilson, 1988). In contrast, it is claimed that

depreciation has more limited potential as an additional earnings management

instrument because of its visibility and rigidity (Young, 1999, pp.11; Beneish, 1998,

pp.5).6

Working capital accruals management is not directly observable. We therefore

use the modified-Jones model (Dechow et al., 1995) to generate estimates of accrual

management. However, evidence suggests this model identifies discretionary accruals

imprecisely due to the confounding effects of factors unrelated to earnings

management in the period (Guay et al. 1996; Healy 1996; Dechow et al. 1995).7

Therefore, we follow Healy (1996, pp.114) and label estimated non-discretionary

accruals as “normal accruals” and estimated discretionary accruals as “abnormal

accruals”. Abnormal accruals are ambiguous in the sense that they measure earnings

management with error. Our research design (discussed below) addresses the

ambiguity in abnormal accruals by conditioning the empirical analysis on the

incentives to manage earnings. When incentives are particularly strong, we can be

more confident that abnormal accruals reflect earnings management activity.

Consistent with recent U.S. studies (e.g., Becker et al., 1998; DeFond and

Subramanyam, 1998), we use a cross-sectional procedure to estimate parameters for

the modified-Jones model. Notwithstanding differences between U.K. and U.S.

GAAP, Peasnell et al. (1999c) show that the cross-sectional version of the modified-

Jones model is capable of capturing relatively subtle instances of accrual management

in U.K. data. A cross-sectional approach helps to maximize sample size and

overcomes the survivorship bias problem inherent in the time-series version of the

11

Jones (1991) model.8 A cost of the cross-sectional approach, however, is that it

ignores possible reversals of abnormal accruals from prior periods, thereby reducing

the power of empirical tests to detect earnings management.

The modified-Jones model parameters are estimated using the following cross-

sectional OLS regression:9

iii REVWC νωω +∆+= 10 , (1)

where WCi is working capital accruals for firm i, defined as the change in non-cash

current assets minus the change in current liabilities, ∆REVi is the change in revenue,

ω0 and ω1 are regression coefficients, and νi is the regression residual. The model is

estimated separately for each industry and year combination. All variables are scaled

by lagged total assets to reduce heteroskedasticity. Industry-year portfolios with less

than ten observations are excluded from the analysis to allow more efficient estimation

of the regression parameters.

Following Dechow et al. (1995), abnormal accruals (AA) for the modified-

Jones model are defined as follows:

)](ˆˆ[ 10 iiii RECREVWCAA ∆−∆+−= ωω , (2)

where 0ω̂ and 1ω̂ are the OLS regression estimates of ω0 and ω1 obtained from

equation (1) and ∆RECi is the change in receivables.

Research Design

In view of the potential ambiguity in estimated abnormal accruals, we test for

the association between earnings management and board effectiveness by focusing on

a situation in which the incentive for income-increasing earnings management is

12

expected to be particularly strong. We begin by defining unmanaged earnings (UME)

as reported earnings (EARNt) minus abnormal accruals (AAt). We expect the

incentives for income-increasing earnings management to be particularly strong when

UME falls below target earnings. Burgstahler and Dichev (1997) examine two

earnings targets. Specifically, they suggest that managers will seek to avoid reporting

losses (EARNt < 0) and earnings declines (EARNt < EARNt-1). Another possible

target is meeting analysts’ earnings forecasts. Degeorge et al. (1999) find that while

managers appear to manipulate reported earnings upwards to meet analysts’ forecasts,

earnings management to avoid losses and earnings declines proves predominant. We

therefore follow Burgstahler and Dichev (1997) and use the avoidance of losses and

earnings declines as the targets for this study. Our predictions are that income-

increasing accruals will be more likely when UME < 0 and when UME < EARNt-1.10

Our research design is intended to test whether NEDs constrain earnings

management to meet earnings targets and whether the constraint is more pronounced

following the publication of the Cadbury Report than it was beforehand. In the

following tests, we define NEDs as board members classified as “non-executive” in

the annual reports of our sample companies.11 We estimate the following OLS

regression model:

, 9

876543

211210

ii

iiiiii

iiiii

CFO

RELLEVSIZEAUDBLOCKINSTOWN

BRDOWNSIZEBRDCADOUTCADOUTAA

εδ

δδδδδδ

δδγλλλ

++

++++++

++⋅+++=

(3)

whereAA = abnormal accruals computed using the modified-Jones model;

OUT = number of non-executive board members divided by total board size;

CAD = 1 if the observation is from the pre-Cadbury period, 0 otherwise;

BRDSIZE = total number of board members;

13

BRDOWN = fraction of equity owned by executive directors;

INSTOWN = fraction of equity owned by institutional investors;

BLOCK = 1 if at least one external stakeholder holds ≥ 10% of the outstanding

equity, 0 otherwise;

AUD = 1 if the firm is audited by a Big 6 auditor, 0 otherwise;

SIZE = market value of equity;

LEV = leverage (debt-to-assets);

REL = 1 if earnings before abnormal accruals < the industry median, 0

otherwise;

CFO = cash flow from operations.

We partition sample observations according to whether UME exceeds or falls

short of the targets specified above and estimate equation (3) separately for each

subset. If earnings management is taking place and our prediction about the role of

NEDs is correct, then we would expect the estimated coefficient on OUT to be

negative and significant. Moreover, if hypothesis one is correct and NEDs are

performing their monitoring duties more effectively in the post-Cadbury period, then

the estimated coefficient on OUT for the post-Cadbury regime (λ1) should be more

negative than that for the pre-Cadbury regime (λ1 + γ1) when UME is below-target. In

other words, we expect λ1 to be negative and significant and γ1 to be positive and

significant when regression (3) is estimated for the below-target sub-samples.

Conversely, we have no predictions for the coefficients on OUT and OUT·CAD when

regression (3) is estimated for the sub-samples where UME is above-target, since

systematic income-increasing accrual management is not predicted to occur in these

circumstances.

Prior research suggests that accrual management may be related to the level of

insider ownership (Warfield et al. 1995), external ownership structure (Rajgopal et al.,

1999), auditor quality (Becker et al. 1998), the probability of debt covenant violation

14

(DeFond and Jiambalvo, 1994), political costs (Han and Wang, 1998), smoothing

(DeFond and Park, 1997), and operating cash flow performance (Dechow et al., 1995).

We therefore include proxies for these potential determinants of abnormal accruals as

additional control variables in regression (3). We also control for board size in our

empirical tests given (a) the well-documented positive association between board size

and the proportion of NEDs and (b) the suggestion that board effectiveness may be

negatively related to board size (Yermack, 1996). Variable definitions, together with

their expected relation with AA, are presented in table 1. Consistent with our

predictions for board composition, the predicted signs for the ownership structure,

auditor quality and board size variables relate only to those instances where the

incentive for earnings management is high (i.e., when UME < target). The predictions

for the remaining variables apply to both above- and below-target samples.

Sample and Data

The relation between board composition and abnormal accruals is examined

using a sample of U.K.-incorporated quoted companies for a period spanning the

publication of the Cadbury Report (1992). We begin by defining two sub-periods that

capture the pre- and post-Cadbury regimes. The pre-Cadbury period comprises the

fiscal years 1990 and 1991, where a fiscal year includes all firms with financial year-

ends falling on or between 1 June year t and 31 May year t+1. Our pre-Cadbury

period therefore includes firms with year-ends on or between 1 June 1990 and 31 May

1992. Using a similar approach, the post-Cadbury period comprises the fiscal years

1994 and 1995 and therefore includes firms with financial year-ends falling on or

between 1 June 1994 and 31 May 1996.12 We use a balanced sample design to assess

whether the association between abnormal accruals and board composition differs

15

between the pre- and post-Cadbury periods. A balanced design allows each sample

firm to serve as its own control, thereby eliminating any differences that might result

from temporal variation in sample composition. Firms must therefore have at least one

observation in both the pre- and post-Cadbury periods to be included in the final

sample.

The modified-Jones model is estimated for each industry (Datastream level-6)

and year combination using all firms on the Datastream Active and Research files

with available accruals data.13 The number of firms used to estimate the model in 1990

(1991, 1994 and 1995) is 601 (601, 651 and 657). The maximum number of

observations for any given industry-year combination is 56 (general engineering,

1995). The mean (median) estimation portfolio size is 21 (18) observations.

Board data are collected using the following sampling procedure. For each

sample year we select the largest 1000 listed firms based on December market

capitalization reported in the London Share Price Database. We then exclude all

financial firms (SIC codes 60-69) because (a) they are subject to fundamentally

different regulatory regimes and internal governance structures and (b) the efficacy of

the modified-Jones model at detecting accrual management in financial firms has not

been documented in the literature. In addition, we also exclude all regulated utilities

(SIC codes 40-44, 46, 48-49) because of potential differences in their incentives and

opportunity to manage earnings.

The Price Waterhouse Corporate Register14 is used to collect board

composition data. The Corporate Register is also the main source of managerial stock

ownership data, supplemented where necessary with data from the annual reports.

Given the inability in the U.K. to determine the voting and control rights of non-

beneficial shareholdings, we restrict our definition of ownership to beneficial

16

shareholdings only. For the same reason, we also exclude all family and family-related

holdings, together with shares held in employee pension and stock option plans. Data

on external ownership are collected from the Stock Exchange Official Yearbook while

data on auditor type are collected from the Corporate Register. All remaining data are

obtained from Datastream (Active and Research files).

The intersection of the samples for which we have data for abnormal accruals,

board composition, and all control variables yields an initial set of 1683 firm-year

observations, comprising 811 observations for the pre-Cadbury period and 872

observations for the post-Cadbury period and representing 650 individual firms drawn

from 35 Datastream level-6 industry groups. Of these, 360 firms from 30 Datastream

level-6 industry groups have at least one observation in both the pre- and post-

Cadbury periods.15 Thirty-five firms (10%) have one observation in each of the pre-

and post-Cadbury periods, 110 firms (30%) have two observations in one period and

one in the other and 215 firms (60%) have two observations in each period. Our final

sample therefore comprises 1260 firm-year observations, split equally between the

pre- and post-Cadbury periods. Annual sample sizes are 301 (1990), 329 (1991), 346

(1994) and 284 (1995).16

4. PRELIMINARY RESULTS

Descriptive Statistics

Over the 126 industry-year combinations for which the modified-Jones model

is estimated, the mean (median) R-squared statistic is 18% (11%). The mean value of

the coefficient on ∆REV (ω1) in the modified-Jones model is 0.015 which is

insignificantly different from zero (p = 0.170). In the pre-Cadbury sample, 93 firms

(15%) are classified as below target when UME is benchmarked against zero, while

17

330 firms (52%) are classified as below target when UME is benchmarked against

EARNt-1. Comparable numbers for the post-Cadbury sample are 93 firms (15%) and

264 firms (42%), respectively.

Descriptive statistics for %NED and the additional control variables used in the

study are reported in table 2, partitioned according to the pre- and post-Cadbury

periods. Results indicate that while board size (BRDSIZE) has remained relatively

constant across the period at approximately eight members, the proportion of non-

executive board members has risen from 37.5% in the pre-Cadbury period to 43% in

the post-Cadbury period (difference significant at the 0.01 level). In other words,

boards typically contained between three and four NEDs in the post-Cadbury period,

compared with slightly less than three in the pre-Cadbury period. The increasing use

of NEDs in the post-Cadbury period is consistent with the move towards more

independent boards documented by Peasnell et al. (1998) and the Cadbury

Compliance Statement (1995). Significant changes across the sample window are also

apparent for a number of the control variables in table 2. For example, SIZE, BLOCK

and AUD are all significantly higher in the post-Cadbury period at the 0.01 level,

while BRDOWN, INSTOWN and CFO show a significant decline over the period.

Leverage (LEV) also appears to have declined during the sample period, although the

difference is not significant at conventional levels.

Our empirical tests of the link between board effectiveness and earnings

management are based on a prediction of income-increasing accruals when UME falls

short of target earnings. Table 3 reports mean and median abnormal accruals for the

above- and below-target sub-samples and provides evidence consistent with this

prediction. Panel A presents results for UME benchmarked against zero while panel B

reports findings for UME benchmarked against EARNt-1. Reported earnings are

18

defined as earnings before extraordinary items (Datastream item #182) plus

preference dividends.17 Mean and median abnormal accruals in the below-target sub-

samples (UME < 0 and UME < EARNt-1) are positive and significant in panels A and

B for both the pre- and post-Cadbury samples. These findings support the prediction

that working capital accruals are being managed upwards in both periods as a means

of achieving target earnings. In contrast, average abnormal accruals in the above-target

samples (UME ≥ 0 and UME ≥ EARNt-1) are negative, indicating no systematic

propensity for income-increasing accounting choices in either period when UME

exceeds target earnings.

The earnings management predictions are ambiguous for those firms where

UME undershoots target earnings by a large amount. On the one hand, management

concerns over costly sanctions in the form of additional monitoring (DeAngelo et al.,

1994) and the increased likelihood of dismissal (Weisbach, 1988) suggest a preference

for income-increasing choices. On the other hand, the big bath hypothesis predicts

income-decreasing abnormal accruals as managers seek to store up positive earnings

for future periods (Degeorge et al., 1999; Healy, 1985). Big bath earnings

management would potentially confound our empirical tests of hypothesis one because

it is based on a prediction of income-increasing abnormal accruals when UME is

below target. To assess whether income-increasing earnings management is apparent

across the full range of UME in the below-target subsets, table 3 also reports mean and

median abnormal accruals partitioned by the extent to which UME (standardized by

lagged total assets) undershoots target earnings.18 The partition labeled “Small”

contains firm-years where UME just misses the target, while that labeled “Large”

contains firm-years where the shortfall is greatest. All else equal, the big bath

hypothesis predicts negative abnormal accruals in “Large”. In contrast, estimated

19

abnormal accruals in the “Large” partition are positive and significant at the 0.01 for

both the pre- and post-Cadbury periods. Abnormal accruals are also positive and

significant in the remaining four partitions. These results hold regardless of whether

we define the earnings target as zero (panel A) or last period’s reported earnings

(panel B). The findings suggest that pooling the observations in the below-target sub-

samples is justified since they appear to be relatively homogenous with respect to the

direction of abnormal accrual activity.

Regression Results

Tests of whether NEDs constrain income-increasing earnings management are

presented in table 4. Panel A presents results for the EARNt ≥ 0 target while panel B

presents results for the EARNt ≥ EARNt-1 target. Columns 3–5 contain the results of

estimating regression (3) on the below-target sub-sample while columns 6–8 present

equivalent regressions estimated using the above-target sub-samples. Predictions

regarding the signs for %NED, %NED·CAD, BRDSIZE, BRDOWN, INSTOWN,

BLOCK and AUD only apply to the below-target sub-samples as previously

discussed. In each case, we report three versions of regression (3): M1 omits the CAD

main effect term and its interaction with %NED; M2 includes CAD and its interaction

with %NED; M3 includes CAD interacted with %NED and all other governance

variables.

Focusing initially on the below-target sub-sample in panel A, the estimated

coefficient on %NED in M1 (column 3) is negative but not significant, indicating that

the average constraining effect of NEDs during the full sample period (pre- and post-

Cadbury) was generally weak. When the model is extended to allow the coefficient on

%NED to vary between the pre- and post-Cadbury periods (M2, column 4), however,

20

results indicate a strong negative association between abnormal accruals and %NED in

the post-Cadbury period. Consistent with the findings reported by Peasnell et al.

(1999), the estimated coefficient on %NED is negative and significant (p = 0.06 for a

one-tailed test) in the post-Cadbury period. In contrast, the corresponding coefficient

estimate on %NED for the pre-Cadbury period (λ1 + γ1) is 0.026. In other words, while

NEDs appear to constrain accruals management to meet earnings targets in the post-

Cadbury period, no evidence of a such constraining effect is evident pre-Cadbury. The

estimated coefficient on the %NED·CAD interaction term is positive and significant at

the 0.05 level, indicating that the difference in the association between abnormal

accruals and NEDs for the pre- and post-Cadbury periods is significant. Similar results

are also apparent in M3 (column 5) where the model is extended to include interaction

terms on all additional governance variables: the coefficient on %NED·CAD is

positive and significant at the 0.01 level, with the significant negative association

between abnormal accruals and %NED confined to the post-Cadbury period. These

results provide support for the hypothesis that boards are discharging their financial

reporting duties more effectively in the post-Cadbury period.

Of the remaining governance variables, none are significant at conventional

levels in M1 and M2 for the below-target sample. However, results for M3 (column 5)

indicate important differences for several variables between the pre- and post-Cadbury

periods. For example, while the coefficient on AUD is insignificant at conventional

levels in the post-Cadbury period, it is negative and significant in the pre-Cadbury

period.19 Thus, our pre-Cadbury results are consistent with the U.S. evidence reported

by Becker et al. (1998) and Francis et al. (1998) that Big 6 auditors appear to constrain

accruals manipulation. We also observe a structural break for BRDOWN in M3: while

abnormal accruals and insider ownership are negatively related in the post-Cadbury

21

period (p = 0.05, one-tailed test) as predicted, the estimated coefficient on BRDOWN

is close to zero in the pre-Cadbury period. While we offer no formal explanation for

the temporal shifts in relation to AUD and BRDOWN, the significant differences

documented in table 2 for these variables across the sample period coupled with the

general governance changes occurring during the period mean that it is perhaps not

surprising that we also observe structural breaks for these mechanisms. Of the

remaining control variables, only the operating cash flow variable is significant at

conventional levels.

Consistent with the lack of any systematic attempts to artificially boost

reported earnings when UME exceed target earnings, results in panel A provide no

evidence of a link between abnormal accruals and board composition in either sub-

period for the above-target sub-sample (columns 6-8). Similarly, there is little

evidence that any of the additional governance variables are systematically associated

with earnings management activity when UME exceed target earnings. The estimated

coefficients on SIZE, REL and CFO display their predicted signs and are significant at

conventional levels. The negative coefficient on LEV has the opposite sign to that

predicted but is not significant.

Findings presented in panel B of table 4 also support hypothesis one when

unmanaged earnings are benchmarked against EARNt-1, although the results are

slightly weaker than those reported in panel A. For example, when M3 is estimated

using the below-target sub-sample (column 5), the coefficient on %NED is –0.024 (p

= 0.114) in the post-Cadbury period while the %NED·CAD term is positive and

significant at the 0.02 level using a one-tailed test. Although the constraining effect of

NEDs in the post-Cadbury period is somewhat weaker than that reported by Peasnell

et al. (1999) using a larger sample of firms, the results prove clear evidence that the

22

constraining effect of NEDs in the post-Cadbury period is significantly more

pronounced than that in pre-Cadbury period. Further, the structural breaks for

BRDOWN and AUD documented in panel A are again evident. In addition, these

results also suggest that the level of institutional monitoring has declined over the

sample period: the estimated coefficient on INSTOWN is –0.021 for post-Cadbury

period, compared with –0.033 for the pre-Cadbury period. The estimated coefficients

on SIZE, LEV, REL, and CFO are significant at the 0.05 level or better with their

predicted signs. In contrast to the results reported for the below-target partition, no

evidence of a significant negative association between AA and OUT is apparent in

either the pre- or post-Cadbury periods when regression (3) is estimated using the

above target sub-sample (columns 6-8).

In an attempt to further understand the changing nature of the association

between abnormal accruals and board composition during the sample period, we

examine the role of audit committees in the financial reporting process. Boards of

directors often delegate responsibility for oversight of the financial reporting process

to an audit committee staffed by NEDs. Audit committees are widely viewed as

enhancing the board’s capacity to discharge its financial reporting duties effectively

(Cadbury Report, 1992; Klein, 1998). This raises the possibility that the increased use

of such committees documented by the Cadbury Compliance Report (1995) during our

sample period may underlie the structural break in the association between abnormal

accruals and NEDs documented above.20 We examine this issue by re-estimating

regression (3) for the subset of sample firms with an audit committee in both the pre-

and post-Cadbury periods.21 From the initial sample, we were able to unambiguously

identify 139 firms (39%) that had an audit committee in both sub-periods. If the

increasing use of audit committees is the primary factor driving changes in the

23

association between abnormal accruals and board composition during the sample

period, then we would not expect to find evidence of the structural break among firms

that had an operational audit committee throughout the sample period. In contrast,

results provide evidence of a similar structural break for the audit committee sample to

that reported for the full sample. As such, these findings do not support the view that

the documented structural break in the association between abnormal accruals and

NEDs is primarily due to the increasing use of audit committees among sample firms

in the post-Cadbury period.

To summarise, the findings presented in table 4 are consistent with the

hypothesis that boards, and NEDs in particular, are discharging their financial

reporting responsibilities more effectively in the post-Cadbury period.22 Moreover, the

lack of any significant association between abnormal accruals and board composition

in the pre-Cadbury period is consistent with the unfettered use of creative accounting

practices that motivated the formation of the Cadbury Committee in the first place.

However, while these findings are consistent with the hypothesis that the Cadbury

Report (1992) helped raise the level of board monitoring, our empirical tests do not

directly demonstrate that the observed structural break in the relation between

abnormal accruals and board composition is a consequence of the changes brought

about by the Cadbury Report and the associated governance debate. In the next

section, therefore, we extend our analysis to consider two alternative explanations that

may be driving our results.

5. ALTERNATIVE EXPLANATIONS

The FRS3 Hypothesis

Pope and Walker (1999) and Beattie et al. (1994) provide evidence that prior to

the introduction of FRS 3, U.K. companies used the flexibility inherent in the

24

classification of extraordinary items to manage reported earnings. The introduction of

FRS 3 in July 1993 effectively outlawed the use of extraordinary items for financial

reporting purposes and in so doing eliminated a potentially important earnings

management tool. In the context of the present study, FRS 3 limits the use of

extraordinary items to our pre-Cadbury sub-period only. Recall that our basic results

focus on earnings before extraordinary items (Datastream item #182). If, prior to FRS

3, firms were using extraordinary items to manipulate reported earnings, then proxying

for earnings management using accrual-based measures will generate lower power

tests in the pre-Cadbury period, relative to the post-Cadbury period. This raises the

possibility that our inability to document an association between earnings management

and board composition in the pre-Cadbury period may be due to our failure to use the

appropriate earnings management instrument, rather than because of any improvement

in board monitoring resulting from the Cadbury Report.

To test this alternative explanation, we collect data on extraordinary items (XI)

reported by firms in the pre-Cadbury sample. From the initial sample of 630 firm-year

observations, data are available for 617 firm-years (98%) from Datastream. We begin

by testing to see whether firms in the pre-Cadbury period were using XIs as a means

of achieving target earnings when unmanaged earnings undershoot the target. For the

purpose of the following tests, we construct a new measure of unmanaged earnings

(UMEXI) defined as reported earnings after extraordinary items, plus preference

dividends. We define a negative (positive) XI as income-increasing (decreasing).

Descriptive statistics for XIs are presented in table 5. Panel A reports findings when

UMEXI is benchmarked against zero while panel B reports results when UMEXI is

benchmarked against last period’s reported earnings.

25

Results reported in column 2 of table 5 indicate that 310 firm-years (50%) are

associated with an XI. Of these, 77% (240 observations) report a negative XI. These

findings are consistent with Pope and Walker (1999) and confirm prior suggestions

(e.g., Smith, 1992) that the majority of XIs reported by U.K. firms were income-

increasing in nature. The mean (median) XI is –£2.7 million (£0). Results for XIs

partitioned according to the level of UMEXI are reported in columns 3 and 4 of table 5

and provide evidence consistent with the prediction that prior to FRS 3 firms used XIs

as a way of managing reported earnings upwards when UMEXI fell short of target

earnings. Findings hold when the earnings target is defined as either EARN ≥ 0 (panel

A) or EARN ≥ EARNt-1 (panel B). For example, almost 77% of the 56 observations

with UMEXI < 0 have a negative XI, compared with only 35% of observations with

UMEXI ≥ 0 (difference significant at the 0.01 level). The mean (median) XI is –4% (–

3%) of total assets for firms where UMEXI < 0, compared with zero for firms with

UMEXI ≥ 0. These differences are significant at the 0.01 level. Similarly, when

UMEXI is benchmarked against EARNt-1 (panel B), 54% of the 359 observations in

the below-target group reported an income-increasing XI, compared with only 17% of

above-target observations (difference significant at 0.01 level). These results therefore

provide clear evidence that firms in the pre-Cadbury sample were using extraordinary

items to manage reported earnings upwards when unmanaged earnings fell below

target earnings.

Having established that XIs appear to have been used by companies in the pre-

Cadbury period to manipulate reported earnings, we test whether NEDs constrained

the use of XIs among below-target firms in the same way that they appear to constrain

abnormal accruals post-Cadbury. Table 6 presents results of regressions relating XIs

(scaled by lagged total assets) to board composition (%NED) and a series of control

26

variables. As in our abnormal accrual tests reported in section 4, we estimate the

regression separately for above- and below-target samples. If NEDs helped constrain

income-increasing XIs in the pre-Cadbury period, then we would expect to observe a

significant positive coefficient on %NED for the below-target sub-samples.23 Results

in table 6 provide no evidence of a significant positive coefficient on %NED in any of

the sub-samples for either of the earnings targets.24 As such, these findings do not

support the hypothesis that a change in the earnings management instrument resulting

from the introduction of FRS 3 is responsible for the structural break in the association

between abnormal accruals and board composition reported in section 4. Of the

remaining variables in table 6, the coefficients on BRDOWN (above-target samples),

SIZE (above-target samples), LEV and REL are generally significant with their

predicted signs, indicating a preference for income-increasing XIs among manager-

controlled firms, large firms, firms with high leverage, and firms with unmanaged

earnings below the industry average.

Temporal Variation in the Stimulus for Earnings Management

While managers may face strong incentives to exercise their financial reporting

discretion in all accounting periods, the underlying rationale may vary across time. We

conjecture that the dominant stimulus for accrual management will depend on the

specific circumstances facing the firm which will be governed, at least in part, by the

general economic climate. Temporal shifts in general economic performance,

therefore, are expected to lead to variation in the stimulus for earnings management.

The sample period examined in this study spans two contrasting periods of general

economic performance: the pre-Cadbury window (1990-1991) is associated with a

recessionary period, while the post-Cadbury period (1994-1995) is associated with

27

higher growth and improved economic performance. Therefore, if differences in

underlying economic performance affect either the propensity or stimulus for earnings

management (or both), our failure to observe a systematic association between

abnormal accruals and board composition in the pre-Cadbury period may simply

reflect a failure to consider the appropriate earnings management stimulus. More

specifically, the desire to manage earnings upwards to meet pre-determined earnings

targets in the pre-Cadbury period may have been dominated by other concerns.

Prior research provides evidence that managers select income-increasing

accounting methods as a means of avoiding costly debt covenant violation (e.g.,

DeFond and Jiambalvo, 1994). From table 2 we note that leverage is higher in the pre-

Cadbury period. To the extent that leverage proxies for the likelihood of debt contract

violation (Press and Weintrop, 1990), it is possible that earnings management activity

in the pre-Cadbury period was directed more towards avoiding or delaying technical

breaches of accounting-based debt contracts, rather than at attaining specific earnings

targets. If this was indeed the case, then the constraining effect of NEDs is more likely

to have been evident for high leverage firms, rather than for firms with UME less than

target earnings.25

We test this prediction by assigning pre-Cadbury firm-year observations to

quintile portfolios formed on the basis of leverage. Using these quintile portfolios, we

construct a “high leverage” partition consisting of all firm-years in the top two

quintiles of the leverage distribution. If NEDs constrain accrual-based earnings

management activity aimed at deferring or avoiding the costs of debt contract

violations, then we would expect to observe a negative association between AA and

%NED for the high leverage partition. For comparative purposes, we also examine the

association between abnormal accruals and %NED for a “low leverage” partition

28

consisting of all firm-years in the bottom two quintiles of the leverage distribution.

Since we do not expect these firms to systematically manage earnings upwards, no

association between AA and %NED is predicted for this partition. Results are

presented in table 7. While the estimated coefficient on %NED in the high leverage

partition is negative as predicted, it is not significant at conventional levels. As such,

these results provide no evidence to support the view that changes in the stimulus for

earnings management over our sample period are responsible for the structural break

in the association between abnormal accruals and board composition reported in

section 4.

6. CONCLUSIONS

This paper examines the association between the composition of the board of

directors and accrual management activity in two contrasting governance regimes in

the U.K.. Using a balanced sample, it extends the work of Peasnell et al. (1999a) by

examining whether the constraining effect of non-executive directors on income-

increasing accruals management differs between the pre- and post-Cadbury periods.

Results provide evidence of accrual management to meet earnings targets in both the

pre- and post-Cadbury periods. Perhaps unsurprisingly, these results suggest that the

recent changes in the U.K. governance system have failed to completely eliminate

earnings management activity. Regarding the specific link between earnings

management and board composition, results for the post-Cadbury period indicate less

income-increasing accrual management to avoid earnings losses or earnings declines

when the proportion of non-executive directors is high. In contrast, we find no

evidence of an association between the degree of accrual management and the

proportion of non-executive directors in the pre-Cadbury period. Additional tests

indicate that the increasing use of audit committees during the sample period does not

29

appear capable of explaining the observed structural break in the association between

abnormal accruals and board composition.

Our results contribute to the existing literature in several ways. First, we show

that, given appropriate conditions, NEDs can help to constrain earnings management

and hence increase the quality of financial reports. These results confirm those

reported by Peasnell et al. (1999a) and support the view that the board’s effectiveness

at monitoring management is a positive function of the proportion of non-executive

members. Secondly, our results suggest that appropriately structured boards are

discharging their financial reporting duties more effectively following the issuance of

the Cadbury Report. As such, these findings are consistent with the view that the

publication of the Cadbury Report has had a material impact on the way in which U.K.

boards operate.

A significant limitation of this study is our inability to provide evidence of a

direct causal relationship between the publication of the Cadbury Report and the

structural break documented between abnormal accruals and board composition. As a

result, we are unable to reject the possibility that this structural break may be due to

one or more factors unrelated to the Cadbury Report. To address this issue, we

consider two competing explanations for our findings. First we test for evidence of a

change in the earnings management instrument as a result of the introduction of FRS

3. Secondly, we test whether temporal variation in the stimulus for earnings

management can explain our findings. Results suggest that neither explanation can

account for the changing nature of the association between abnormal accruals and

board composition over the sample period. However, while these findings help to

eliminate two possible explanations for our results, the possibility remains that our

findings are capturing something other than the impact of the Cadbury Report.

30

End Notes1 The Cadbury Report also highlights the importance of the statutory audit as a control

mechanism in the financial reporting process.2 A similar move towards board empowerment has been documented in the U.S. by Millstein

and MacAvoy (1998) and Lorsch (1995).3 See for example, “Cadbury successor may change board reforms” (Financial Times, 1995),

“The old boy network is put out to grass” (Times, 1994), and the report by the Institutional

Shareholders Committee (1991) on the role and duties of directors.4 For example, “Listed directors against increased Cadbury Code requirements” (The

Independent, 1996), “Call to replace Cadbury and Greenbury Codes” (The Independent,

1996), “Chewing over Cadbury” (Times, 1994), and ‘New image: old message’ (Times, 1994).5 These studies assume that in the absence of a reliable means of distinguishing between the

competing incentives for earnings management (i.e., opportunism, efficient contracting, or

signalling), NEDs attempt to constrain the subset of accounting choices that most likely reflect

managerial opportunism. Prior research generally associates opportunistic behavior by

managers with income-increasing accounting choices (Holthausen 1990; Watts and

Zimmerman 1986). Consequently, these studies test for a negative association between

income-increasing earnings management and the presence of NEDs.6 We re-ran the tests reported in this paper using total accruals in place of working capital

accruals, with almost identical results.7 Confounding factors include exogenous shocks to firm performance, strategic operating

decisions, and the reversal of prior-period discretionary accruals.8 The procedure has the additional advantage over the time-series approach that it does not

require the assumption that parameter estimates remain stable over time.9 In the original specification of the modified-Jones model (Dechow et al. 1995), adjusting the

∆REV term for the change in receivables (∆REC) is done after equation (1) has been fitted. In

other words, for estimation purposes the Jones and modified-Jones models are equivalent.

Recently, however, researchers have begun to estimate cross-sectional versions of the

modified-Jones model in which ∆REV is adjusted by ∆REC at the estimation stage (e.g.,

Rajgopal et al. 1999). We repeated our empirical tests using this alternative specification of

the modified-Jones model. In all cases, the findings were consistent with those based on

equation (1).10 It should be noted that below-target UME might not necessarily lead managers to prefer

income-increasing earnings management. In particular, it may be either infeasible or

prohibitively costly to manage earnings upwards to meet the target when UME falls far short.

31

In these circumstances, managers may even prefer to adopt a “big bath” strategy and make

income-decreasing accruals, effectively storing up income-increasing earnings management

options for future periods (Degeorge et al. 1999; Healy 1985). Whether this actually happens

is an empirical issue that we address in section 4.11 Our definition of a NED makes no distinction between non-executives without business or

financial links to management (independent NEDs) and non-executives with such links (so

called “greys”). Limitations in company disclosures prior to Cadbury preclude any attempt to

develop a reliable measure of independence that can be used consistently across both the pre-

and post-Cadbury periods. All else equal, the inclusion of greys is likely to reduce the power

of our tests. As a check on the robustness of the results for the post-Cadbury period, we report

in the results section a supplementary test where NEDs are restricted to those with no

affiliations to management.12 We exclude the period June 1992 to December 1992 from the pre-Cadbury period in an

effort to reduce contamination of our results by firms that changed their board structure in

response to the Cadbury Committee’s draft report published in May 1992. We exclude the

period December 1992 to May 1994 from the post-Cadbury period because this represented a

transition period during which time companies were responding to the recommendations

contained in the Committee’s final report.13 The sample of firm-years used to test hypothesis one is a subset of the firm-year

observations used to estimate regression (1).14 The Corporate Register is published quarterly by Hemmington Scott Ltd. and includes data

for all firms listed on the London Stock Exchange. Hemmington Scott up-date their database

using information from the London Stock Exchange and Reuters. The publication lag for the

register is approximately one month. We use the September edition of the Corporate Register

in calendar year t to identify board composition for firms with year-ends between March of

year t and February of year t+1.15 Sample firms are fairly evenly distributed across industry groups. The largest industry

represented in the final sample is general engineering with 135 firm-year observations

(10.7%). None of the remaining industries account for more than 6% of the final sample.16 As a check on the robustness of our results to the use of a balanced sample design, we

repeated all tests using an unbalanced design in which regression (3) was estimated using all

1683 firm-year observations with available data. Findings provided even stronger evidence of

a structural break than those reported for the balanced sample. However, it should not be

forgotten that the sample firms change in the unbalanced design and so we cannot rule out the

possibility that firm-specific factors might be driving the result.

32

17 Almost identical results are obtained using reported earnings measured inclusive of

extraordinary items in the pre-Cadbury period.18 Virtually identical results are obtained using unscaled UME, as well as UME scaled by the

absolute magnitude of working capital accrual balances.19 The coefficient on AUD in the pre-Cadbury period is –0.028 (i.e., –0.0121 – 0.0159), which

is significant at the 0.1 level using a one-tailed test.20 However, the effectiveness of audit committees ultimately depends on board composition

(Vicknair et al., 1993). It is therefore unclear whether the presence of an audit committee will

have an incremental effect on earnings management beyond that of board composition.21 In addition, we also regressed abnormal accruals for the below-target samples on both

%NED and a binary variable (AC) indicating the presence of an audit committee, using data

for the post-Cadbury period. While the estimated coefficient on %NED was consistent with

that reported in table 4, the coefficient on AC never attained significance at conventional

levels. Moreover, the coefficient on AC remained insignificant even after %NED was

excluded from the regression. These findings suggest that the negative association between

abnormal accruals and %NED reported in the paper is not the result of an omitted variables

problem caused by a failure to include an audit committee variable in the empirical model.22 To assess the robustness of our post-Cadbury results to the definition of NEDs, we regressed

abnormal accruals on a measure of independent NEDs, plus the vector of control variables, for

the below-target samples. We classified as grey all NEDs whose board tenure exceeds ten

years, who are related to management, or who are ex-managers, consultants, lawyers, financial

advisors, or who are involved in a reciprocal interlock. All remaining NEDs were defined as

independent. Results based on this measure of independent NEDs provided even stronger

evidence of the predicted negative association between earnings management and board

composition than those reported using %NED. These results suggest that the significant link

between abnormal accruals and the proportion of NEDs documented in the post-Cadbury

period is robust to the specific definition of NEDs.23 Consistent with our prior tests, we have no predictions regarding the association between XI

and OUT when the regression is estimated for the above-target samples, since systematic

income-increasing accrual management is not predicted to occur in these circumstances.24 In addition to the OLS regressions, we also estimated binary and multinomial logit models

relating the probability of a firm reporting an extraordinary item to the proportion of NEDs.

Without exception, the estimated coefficient on %NED never attained significance at the 10%

level or better.

33

25 Note, however, that earnings management to avoid technical violation of bond covenants

could be in the interests of shareholders because it may reduce the overall costs to the firm. As

such, it is not necessarily the case that the board will automatically seek to constrain this form

of earnings management.

34

REFERENCES

ASB, 1992. Reporting Financial Performance. Milton Keynes: ASB Publications

Bange, M.M and W.F.M. De Bondt. 1998. R&D Budgets and Corporate Earnings

Targets’, Journal of Corporate Finance 4: 153-184.

Bank of England. 1983. The composition of company boards in 1982. Quarterly

Bulletin March: 66.

Bank of England. 1988. Composition of company boards, Quarterly Bulletin May:

242-245.

Bartov, E. 1993. The Timing of Asset Sales and Earnings Manipulation, The

Accounting Review 68: 840-855.

Beasley, M.. 1996. An empirical Analysis of the relation between the board of director

composition and financial statement fraud. The Accounting Review 71: 443-465.

Beattie, V., S. Brown, D. Ewers, B. John, S. Manson, D. Thomas, and M. Turner.

1994. Extraordinary Items and Income Smoothing: A Positive Accounting

Approach, Journal of Business, Finance and Accounting 21: 791-811.

Becker, C. L., M. L. DeFond, , J. Jiambalvo and K. R. Subramanyam. 1998. The effect

of audit quality on earnings management. Contemporary Accounting Research 15(1):

1-24.

Beneish, M. D. 1998. Discussion of “Are accruals during initial public offerings

opportunistic?” Review of Accounting Studies forthcoming.

Black, E.L., K.F. Sellers and T. Sheehy. 1998. Earnings Manipulation Using Asset

Sales: An International Study of Countries Allowing Noncurrent Asset Revaluation,

Journal of Business, Finance and Accounting 25: 1089-1118.

Brickley, J., J. Coles and R. Terry. 1994. Outside directors and the adoption of poison

pills. Journal of Financial Economics 35: 371-332.

Burgstahler, D. and I. Dichev. 1998. Earnings management to avoid earnings

decreases and losses. Journal of Accounting and Economics 24: 99-126.

Bushee, B. J. 1998. The influence of institutional investors on myopic R&D

investment behaviour. The Accounting Review 73(3): 305-333.

Byrd, J. W. and K. A. Hickman. 1992. Do outside directors monitor managers?

evidence from tender offer bids. Journal of Financial Economics 32: 195-222.

Cadbury Report. 1992. Report of the Committee on the Financial Aspects of

Corporate Governance. London: Gee.

Cadbury Compliance Report. 1995. Report of the Committee on the Financial Aspects

35

of Corporate: Compliance with the Code of Best Practice. London: Gee.

DeAngelo, H. L., L. DeAngelo and D. J. Skinner. 1994. Accounting choice in troubled

companies. Journal of Accounting and Economics 17: 113-144.

Dechow, P., R. Sloan and A. Sweeney. 1996. Causes and consequences of earnings

manipulation: an analysis of firms subject to enforcement actions by the SEC.

Contemporary Accounting Research 13: 1-36.

Dechow, P., R. Sloan and A. Sweeney. 1995. Detecting earnings management.

The Accounting Review 70: 193-225.

DeFond, M. L. and K. R. Subramanyam. 1998. Auditor changes and discretionary

accruals. Journal of Accounting and Economics 25: 35-67.

DeFond, M. L. and C. W. Park. 1997. Smoothing income in anticipation of future

earnings. Journal of Accounting and Economics 23: 115-139.

DeFond, M. L. and J. Jiambalvo.1994. Debt covenant violation and the manipulation

of accruals. Journal of Accounting and Economics 17: 145-176.

Degeorge, F., J. Patel and R. Zeckhauser. 1999. Earnings management to exceed

thresholds. Journal of Business 27: 1-33.

Fama, E. F. and M. C. Jensen. 1983. Separation of ownership and control. Journal of

Law and Economics 26: 301-325.

Francis, J. R., E. L. Maydew and C. H. Sparks. 1998. The role of Big 6 auditors in the

credible reporting of accruals. Auditing: A Journal of Practice and Theory

forthcoming.

Gilson, R. J. and R. Kraakman. 1991. Reinventing the outside director: an agenda for

institutional investors. Stanford Law Review 43: 863-906.

Griffiths, I. 1986. Creative Accounting. London: Firethorn Press.

Guay, W., S. P. Kothari, R. Watts. 1996. A market-based evaluation of discretionary

accrual models. Journal of Accounting Research 34(supplement): 83-105.

Han, J. C. Y. and S. Wang. 1998. Political costs and earnings management of oil

companies during the 1990 Persian Gulf crisis. The Accounting Review 73: 103-117.

Healy, P. 1996. Discussion of “A market-based evaluation of discretionary accrual

models”. Journal of Accounting Research 34: 107-115.

−−−−. 1985. The effects of bonus schemes on accounting decisions. Journal of

Accounting and Economics 7: 85-107.

36

Holthausen, R.W., 1990. Accounting method choice: opportunistic behavior, efficient

contracting, and information perspectives. Journal of Accounting and Economics 12:

207-218.

Klein, A. 1998. Firm performance and board committee structure. Journal of Law and

Economics 41: 137-165.

Lorsch, J. (1995) Empowering the board. Harvard Business Review 73 (January-

February), 107-117.

McNichols, M. and G. P. Wilson. 1988. Earnings management from the provision of

bad debts. Journal of Accounting Research 26: 1-31.

Millstein, I. M. and P. W. MacAvoy. 1998 The active board of directors and

performance of the large publicly traded corporation. Columbia Law Review 98:

1283-1321.

Patton, A. and J. C. Baker. 1987. Why won’t directors rock the boat? Harvard

Business Review 65(6): 10-18.

Peasnell, K. V.. 1998. Discussion of Earnings management using asset sales: an

international study of countries allowing noncurrent asset revaluation. Journal of

Business Finance and Accounting 25: 1319-1324.

Peasnell, K. V., P. F. Pope and S. Young. 1999a. Outside directors, board

effectiveness and abnormal accruals. Working paper, Lancaster University.

Peasnell, K.V., P.F. Pope and S. Young. 1999b. Directors: Who are they?

Accountancy 1 23, 114.

Peasnell, K.V., P.F. Pope, and S. Young. 1999c. Detecting earnings management

using cross-sectional abnormal accrual models. Working paper, Lancaster

University.

Peasnell, K. V., P. F. Pope and S. Young. 1998. A new model board. Accountancy

July: 115.

Pope, P. F. and M. Walker. 1999. International differences in the timeliness,

conservatism and classification of earnings. Journal of Accounting Research

forthcoming.

Press, E. G. and J. B. Weintrop. 1990. Accounting based constraints in public and

private debt agreements: their association with leverage and their impact on

accounting choice. Journal of Accounting and Economics 12: 65-95.

Rajgopal, S., M. Venkatachalam and J. Jiambalvo. 1999. Is institutional ownership

associated with earnings management and the extent to which stock prices reflect

37

future earnings? Working paper, University of Washington.

Rosenstein, S. and J. G. Wyatt. 1990. Outside directors, board independence and

stockholder wealth. Journal of Financial Economics 26: 175-191.

Smith, T. 1992. Accounting for Growth. London: Century Business.

Vicknair, D., K. Hickman, and K. C. Carnes. 1993. A note on audit committee

independence: evidence from the NYSE on “grey” area directors. Accounting

Horizons 7: 53-57.

Warfield, T. D., J. J. Wild, and K. L. Wild. 1995. Managerial ownership, accounting

choices, and the informativeness of earnings. Journal of Accounting and Economics

20: 61-91.

Watts, R. and J. L. Zimmerman. 1990. Positive accounting theory: a ten year

perspective. The Accounting Review 65: 131-156.

−−−− and −−−−. 1986. Positive Accounting Theory. New York: Prentice-Hall.

Weisbach, M. 1988. Outside directors and CEO turnover. Journal of Financial

Economics 20: 413-460.

Yermack, D. 1996. Higher market valuation of a company with a small board of

directors. Journal of Financial Economics 40: 185-211.

Young, S. 1999. Systematic measurement error in the estimation of discretionary

accruals: an evaluation of alternative modelling procedures. Journal of Business,

Finance and Accounting 26: 833-862.

38

TABLE 1Definitions of Variables

Variable Definition Expected Signa

Abnormal accruals (AA) WCt – E(WCt)

Fraction of outside board members (%NED)

NEDt / TOTALt, where NED is the number of non-executive board members and TOTAL is total board size

−

Indicator for time period (CAD) 1 if fiscal year is 1990 or 1991,0 otherwise

?

Board size (BRDSIZE) Ln(TOTALt) +

Fraction of equity owned by directors (BRDOWN)

ESHAREt / TSHAREt −

Indicator for 10% blockholder (BLOCK)

1 if at least one external stakeholder holds ≥ 10% of outstanding equity,0 otherwise

−

Fraction of equity owned by institutional investors (INSTOWN)

ISHAREt / TSHAREt −

Auditor type (AUD) 1 if auditor is Big 6 firm,0 otherwise

-

Leverage (LEV) (LTDt + STDt) / ASSETSt +

Firm size (SIZE) Ln(MVEt-1) −

Indicator for earnings before abnormal accruals relative to median earnings for industry (REL)

1 if UMEt / MVEt-1 < Industry median EARNt / MVEt-1,0 otherwise

+

Operating cash flow (CFO) (OIBDt – WCt) / ASSETSt-1 −

WCt = Working capital accruals (∆non-cash current assets minus ∆current liabilities) scaled by lagged total assets

E(WCt) = Expected working capital accruals computed using the modified-Jones modelESHAREt =Total beneficial ordinary shares held by executive directors at the year endISHAREt =Total shares held by institutional investors at year endTSHAREt = Total number of ordinary shares outstanding at year endMVEt-1 =Market value of equity measured at the beginning of the periodLTDt =Long-term debtSTDt =Short-term debtASSETSt-1 =Total assets measured at the beginning of the periodEARNt =Reported earnings before extraordinary items (Datastream item #182) less preference

dividendsUMEt =EARNt minus (AAt times ASSETSt-1)OIBDt =Operating income before depreciation and amortization

a This column lists each variables expected relation to AA. The predictions for %NED, BRDSIZE,BRDOWN, BLOCK, INSTOWN and AUD refer only to the case when UME is below target.

39

TABLE 2Descriptive Statistics for Board Composition and Additional Control Variables

VariableaPre-Cadbury

(N = 630)Post-Cadbury

(N = 630)p-value fordifferenceb

%NED Mean 0.366 0.434 0.001St. Dev. 0.176 0.143Median 0.375 0.429 0.001

BRDSIZE Mean 8.383 8.313 0.661St. Dev. 3.002 2.631Median 8.000 8.000 0.717

BRDOWN Mean 0.092 0.069 0.002St. Dev. 0.147 0.120Median 0.022 0.009 0.001

INSTOWN Mean 0.248 0.222 0.005St. Dev. 0.163 0.169Median 0.225 0.193 0.004

SIZE Mean 11.817 12.330 0.001St. Dev. 1.419 1.372Median 11.512 12.062 0.001

LEV Mean 0.545 0.530 0.109St. Dev. 0.173 0.168Median 0.546 0.524 0.119

CFO Mean 0.196 0.105 0.001St. Dev. 0.272 0.123Median 0.157 0.104 0.001

BLOCK = 1 (%) 40.63 53.65 0.001

AUD = 1 (%) 82.86 87.78 0.014

REL = 1 (%) 51.11 50.63 0.866

a Variable definitions are presented in table 1.b For the continuous variables, the p-value for the difference in means (medians) is for a t- (Wilcoxon) test. For the indicator variables, the p-value is for a chi-square test.

40

TABLE 3Mean (Median) Abnormal Accrual Estimates Derived from a Cross-Sectional Version of the

Modified-Jones Model

Panel A: Earnings Target ≥ 0

UMEt Relative to Target Extent to which UMEt < Targeta

Sample Period UMEt ≥ 0 UMEt < 0 Small Q3 Q2 Large

Pre-Cadbury1 -0.0120** 0.0684**0.0533** 0.0674** 0.0556** 0.1080**

(-0.0097)** (0.0527) ** (0.0455) ** (0.0504) ** (0.0481) ** (0.0745) **

Post-Cadbury0 -0.0136** 0.0802** 0.0759** 0.0590** 0.0957** 0.0916**

(-0.0087)** (0.0731) ** (0.0651) ** (0.0540) ** (0.0930) ** (0.0769) **

Panel B: Earnings Target ≥ EARNt-1

UMEt Relative to Target Extent to which UMEt < Targetb

Sample Period UMEt ≥ EARNt-1 UMEt < EARNt-1 Small Q3 Q2 Large

Pre-Cadbury -0.0441** 0.0398**0.0184** 0.0374** 0.0646** 0.0887**

(-0.0391) ** (0.0341) ** (0.0157) ** (0.0339) ** (0.0610) ** (0.0739) **

Post-Cadbury -0.0346** 0.0485** 0.0041** 0.0316** 0.0440** 0.0695**

(-0.0253) ** (0.0375) ** (0.0072) ** (0.0261) ** (0.0415) ** (0.0578) **

The pre-Cadbury period consists of 630 firm-years for firms with financial year-ends falling on or between01/06/90 and 31/05/92, of which 93 observations have UMEt < 0 and 330 observations have UMEt < EARNt-1. Thepost-Cadbury period also comprises 630 observations for the same firms, with year-ends falling on or between01/06/94 and 31/05/96, of which 93 observations have UMEt < 0 and 264 observations have UMEt < EARNt-1.UME = unmanaged earnings (EARN – AA).EARN = earnings before extraordinary items and preference dividends.AA = abnormal accruals computed using the modified-Jones model.a Quartile portfolios formed on the basis of UMEt standardised by lagged total assets, for all observations whereUMEt < 0.b Quartile portfolios formed on the basis of UMEt standardised by lagged total assets, for all observations whereUMEt < EARNt-1.* (**) Significantly different from zero at the 0.05 (0.01) level. Significance levels for means (medians) are based ont- (Wilcoxon) tests.

41

TABLE 4OLS Regressions of Abnormal Accruals on Board Composition and a Set of Control Variables.Abnormal Accruals are Estimated Using a Cross-sectional Specification of the Modified-Jones

Model.

Panel A: Earnings Target ≥ 0

UMEt < Target UMEt ≥ Target

M1 M2 M3 M1 M2 M3

VariableaExpected

SignbCoefficient(p-value)c

Coefficient(p-value)c

Coefficient(p-value)c

Coefficient(p-value)c

Coefficient(p-value)c

Coefficient(p-value)c

Intercept (?) 0.1972 0.2300 0.2178 0.0322 0.0223 0.0053(0.001) (0.001) (0.002) (0.032) (0.152) (0.769)

%NED (−) -0.0074 -0.0734 -0.1247 -0.0019 0.0147 0.0110(0.404) (0.066) (0.007) (0.800) (0.216) (0.362)

CAD (?) − -0.0503 -0.0603 − 0.0141 0.0487(0.049) (0.423) (0.033) (0.013)

%NED*CAD (+) − 0.0998 0.1751 − -0.0236 -0.0144(0.041) (0.003) (0.119) (0.360)

BRDSIZE (+) -0.0167 -0.0164 -0.0078 -0.0027 -0.0030 0.0070(0.304) (0.320) (0.739) (0.540) (0.503) (0.267)

BRDSIZE*CAD (?) − − -0.0094 − − -0.0178(0.757) (0.024)

BRDOWN (−) 0.0185 0.0226 -0.1027 -0.0167 -0.0170 -0.0277(0.623) (0.546) (0.045) (0.117) (0.112) (0.076)

BRDOWN*CAD (?) − − 0.1891 − − 0.0162(0.012) (0.418)

INSTOWN (−) -0.0348 -0.0266 0.0032 -0.0132 -0.0150 -0.0151(0.152) (0.214) (0.946) (0.140) (0.095) (0.220)

INSTOWN*CAD (?) − − -0.0329 − − -0.0005(0.598) (0.978)

BLOCK (−) 0.0022 0.0029 -0.0042 -0.0035 -0.0025 -0.0010(0.811) (0.757) (0.380) (0.196) (0.366) (0.788)

BLOCK*CAD (?) − − 0.0114 − − -0.0036(0.541) (0.504)

AUD (−) -0.0149 -0.0178 -0.0121 -0.0043 -0.0041 -0.0032(0.139) (0.098) (0.275) (0.220) (0.245) (0.544)

AUD*CAD (?) − − -0.0159 − − -0.0010(0.557) (0.882)

SIZE (−) -0.0042 -0.0043 -0.0030 -0.0035 -0.0033 -0.0035(0.187) (0.187) (0.265) (0.002) (0.003) (0.002)

LEV (+) -0.0262 -0.0251 -0.0237 -0.0047 -0.0068 -0.0074(0.310) (0.328) (0.360) (0.525) (0.367) (0.328)

REL (+) − − − 0.0595 0.0592 0.0594(0.001) (0.001) (0.001)

CFO (−) -0.0704 -0.0689 -0.0682 -0.0515 -0.0539 -0.0541(0.001) (0.001) (0.001) (0.001) (0.001) (0.001)

Adj-R2 0.1133 0.1233 0.1415 0.4316 0.4335 0.4351F 3.626 3.365 2.905 82.471 69.426 49.614

42

TABLE 4 – Continued

Panel B: Earnings Target ≥ EARNt-1

UMEt < Target UMEt ≥ Target

M1 M2 M3 M1 M2 M3

VariablebExpected

SignbCoefficient(p-value)c

Coefficient(p-value)c

Coefficient(p-value)c

Coefficient(p-value)c

Coefficient(p-value)c

Coefficient(p-value)c

Intercept (?) 0.1022 0.1085 0.0919 0.0127 0.0078 -0.0054(0.001) (0.001) (0.001) (0.495) (0.683) (0.808)

%NED (−) 0.0054 -0.0108 -0.0238 0.0034 0.0196 0.0200(0.637) (0.290) (0.114) (0.715) (0.156) (0.157)

CAD (?) − -0.0096 0.0100 − 0.0116 0.0425(0.345) (0.728) (0.153) (0.083)

%NED*CAD (+) − 0.0248 0.0502 − -0.0314 -0.0285(0.144) (0.020) (0.089) (0.140)

BRDSIZE (+) -0.0032 -0.0040 0.0023 -0.0076 -0.0063 0.0002(0.621) (0.547) (0.813) (0.176) (0.271) (0.974)

BRDSIZE*CAD (?) − − -0.0089 − − -0.0133(0.443) (0.183)

BRDOWN (−) 0.0241 0.0246 -0.0308 -0.0384 -0.0390 -0.0353(0.115) (0.109) (0.102) (0.004) (0.004) (0.058)

BRDOWN*CAD (?) − − 0.0860 − − -0.0069(0.004) (0.783)

INSTOWN (−) -0.0307 -0.0312 -0.0206 -0.0077 -0.0086 0.0018(0.011) (0.011) (0.139) (0.481) (0.433) (0.904)

INSTOWN*CAD (?) − − -0.0121 − − -0.0256(0.635) (0.213)

BLOCK (−) 0.0016 0.0019 -0.0056 -0.0025 -0.0025 0.0008(0.688) (0.637) (0.174) (0.434) (0.450) (0.859)

BLOCK*CAD (?) − − 0.0119 − − -0.0082(0.140) (0.215)

AUD (−) -0.0115 -0.0117 0.0018 -0.0003 -0.0005 -0.0039(0.015) (0.014) (0.823) (0.948) (0.904) (0.541)

AUD*CAD (?) − − -0.0246 − − 0.0070(0.009) (0.413)

SIZE (−) -0.0062 -0.0061 -0.0058 -0.0012 -0.0015 -0.0016(0.001) (0.001) (0.001) (0.201) (0.152) (0.144)

LEV (+) 0.0251 0.0259 0.0256 -0.0258 -0.0264 -0.0284(0.010) (0.008) (0.009) (0.004) (0.004) (0.002)

REL (+) 0.0333 0.0335 0.0341 0.0367 0.0368 0.0364(0.001) (0.001) (0.001) (0.001) (0.001) (0.001)

CFO (−) -0.1019 -0.1029 -0.1005 -0.0416 -0.0417 -0.0418(0.001) (0.001) (0.001) (0.001) (0.001) (0.001)

Adj-R2 0.2315 0.2304 0.2511 0.2140 0.2152 0.2170F 18.867 15.794 12.698 19.108 16.199 11.839

a Variable definitions are presented in table 1.b The predictions for %NED, BRDSIZE, BRDOWN, INSTOWN, BLOCK and AUD only apply to the below targetcolumns.c Where there are predictions on the sign of the coefficient and the estimates accord with that prediction, the p-values are reported on a one-tailed test basis, otherwise two-tailed tests are used..

43

TABLE 5Descriptive Statistics for Extraordinary Items (XI) Reported by Firms in the Pre-Cadbury

Sample.

Panel A: Earnings Target ≥ 0UMEXI Relative to Targeta p-value for

Full sample < 0 ≥ 0 differenceb

Fraction of firm-years with an XI 0.502 0.786 0.474 0.001Fraction of firm-years where XI < 0 0.389 0.768 0.351 0.001

XI (£million)Mean -2.700 -16.921 -1.281 0.002Median 0.000 -3.409 0.000 0.001

XI / Lagged total assetsMean -0.006 -0.041 -0.002 0.001Median 0.000 -0.026 0.000 0.001

N 617 56 561

Panel B: Earnings Target ≥ EARNt-1

UMEXI Relative to Targeta p-value for

All < EARNt-1 ≥ EARNt-1 differenceb

Fraction of firm-years with an XI 0.502 0.593 0.376 0.001Fraction of firm-years where XI < 0 0.389 0.543 0.174 0.001

XI (£million)Mean -2.700 -6.995 3.275 0.001Median 0.000 -0.417 0.000 0.001

XI / Lagged total assetsMean -0.006 -0.013 0.005 0.001Median 0.000 -0.003 0.000 0.001

N 617 359 258

a UMEXI is defined as reported earnings after extraordinary items plus preference dividends.b The difference in sample proportions is assessed using a chi-square test. The difference in means (medians) isassessed using a t- (Wilxocon) test.

44

TABLE 6OLS Regression of Scaled Extraordinary Items on Board Composition and a Set of Control

Variables for the Pre-Cadbury Sample.

Earnings Target ≥ 0 Earnings Target ≥ EARNt-1

UMEXI < 0 UMEXI ≥ 0 UMEXI < EARNt-1 UMEXI ≥ EARNt-1

VariableaExpected

SignbCoefficient(p-value)c

Coefficient(p-value)c

Coefficient(p-value)c

Coefficient(p-value)c

Intercept (?) -0.0338 -0.0135 0.0011 -0.0454(0.694) (0.415) (0.954) (0.146)

%NED (+) -0.0147 -0.0150 -0.0090 -0.0177(0.759) (0.051) (0.296) (0.224)

BRDSIZE (−) 0.0061 -0.0016 -0.0028 -0.0024(0.824) (0.726) (0.559) (0.794)

BRDOWN (+) 0.0408 0.0254 0.0072 0.0474(0.556) (0.018) (0.558) (0.020)

INSTOWN (+) 0.0143 0.0026 0.0080 0.0140(0.726) (0.793) (0.429) (0.478)

BLOCK (+) -0.0119 0.0022 -0.0026 -0.0009(0.446) (0.438) (0.381) (0.875)

AUD (+) 0.0239 0.0009 0.0015 0.0060(0.384) (0.798) (0.748) (0.325)

SIZE (+) 0.0005 0.0024 0.0018 0.0052(0.941) (0.076) (0.212) (0.044)

LEV (−) -0.0625 -0.0126 -0.0349 -0.0166(0.072) (0.112) (0.001) (0.274)

REL (−) − -0.0124 -0.0123 -0.0139(0.001) (0.001) (0.019)

Adj-R2 -0.0289 0.0581 0.0945 0.0761F 0.807 4.837 5.153 2.268N 56 561 359 258a Variable definitions are presented in table 1.b The predictions for %NED, BRDSIZE, BRDOWN, INSTOWN, BLOCK and AUD only apply to the below targetcolumns. The predictions are the opposite signs to those presented in table 4 for the abnormal accrual testsbecause a negative (positive) XI is associated with income-increasing (decreasing) earnings management activity.c The p-values refer to two-tailed tests.

45

TABLE 7OLS Regression of Abnormal Accruals on Board Composition and a Set of Control

Variables for the Pre-Cadbury Period, Partitioned by Leverage. Abnormal Accrualsare Estimated Using a Cross-sectional Specification of the Modified-Jones Model.

High Leveragea Low Leveragea

VariablebExpected

SigncCoefficient(p-value)d

Coefficient(p-value)d

Coefficient(p-value)d

Coefficient(p-value)d

Intercept (?) 0.0102 0.0148 0.0020 0.0884(0.209) (0.695) (0.852) (0.036)

%NED (−) -0.0160 -0.0001 -0.0082 0.0016(0.442) (0.994) (0.746) (0.939)

BRDSIZE (+) − -0.0074 − -0.0051(0.451) (0.688)

BRDOWN (−) − -0.0074 − 0.0076(0.187) (0.809)

INSTOWN (−) − -0.0299 − -0.0311(0.164) (0.226)

BLOCK (−) − 0.0093 − -0.0053(0.165) (0.469)

AUD (−) − -0.0125 − 0.1519(0.081) (0.166)

SIZE (−) − -0.0020 − -0.0090(0.523) (0.009)

REL (+) − 0.0745 − 0.0742(0.001) (0.001)

CFO (−) − -0.0231 − -0.0617(0.033) (0.001)

Adj-R2 -0.0016 0.4339 -0.0036 0.4415F 0.593 22.292 0.105 23.044N 251 251 252 252a Quintile portfolios are formed on the basis of leverage in each fiscal year (1990 and 1991). The “high leverage”partition consists of all observations in the top two quintiles of the leverage distribution, while the “low leverage”partition comprises all observations in the bottom two quintiles.b Variable definitions are presented in table 1.c The predictions for %NED, BRDSIZE, BRDOWN, INSTOWN, BLOCK and AUD only apply to the high leveragepartition.d The p-values refer to two-tailed tests.