The Effect of the Board Composition and its Monitoring Committees on Earnings Management: evidence from Spain

• DOI: http://doi.org/10.1111/j.1467-8683.2007.00654.x
• Date: 01 November 2007
• Author: Beatriz García Osma,Belén Gill‐de‐Albornoz Noguer
• Published date: 01 November 2007

The Effect of the Board Composition

and its Monitoring Committees on

Earnings Management: evidence

from Spain

Beatriz García Osma and

Belén Gill-de-Albornoz Noguer*

We test whether corporate governance mechanisms promoted by best practice codes are effec-

tive in constraining earnings manipulation for a Spanish sample of quoted companies during

the period 1999–2001. In particular, we analyse the association between earnings management

and two key aspects of corporate governance: board composition and the existence of board

monitoring committees. Our results show that board composition signif‌icantly determines

earnings manipulation practices. However, the main role in constraining such practices is not

played by independent directors, as UK and US based research suggests, but by institutional

directors. No correlation is found between the existence of an independent audit committee

and earnings management measures. Finally, the existence and composition of a nomination

committee affects the role of independent directors in constraining earnings manipulation.

Keywords: Corporate governance, earnings management, discretionary accruals

1. Introduction

Large quoted companies are characterised

by having dispersed ownership struc-

tures. This implies that shareholders do not

exert effective control on managers, which

probably increases the likelihood of managers

behaving opportunistically to achieve their

particular interests. Financial scandals occ-

urred recently, such as Enron, Xerox or World-

com, represent extreme examples of such

opportunistic behaviour that have under-

mined investors’ credibility and put directors

and auditors under the scrutiny of regulators

worldwide. In an attempt to recover investor

conf‌idence in the management of quoted com-

panies, there has been an international trend in

recent years towards developing and imple-

menting good governance codes. As pointed

out by Shleifer and Vishny (1997), corporate

governance deals with the ways in which suppliers

of f‌inance to corporations assure themselves of

getting a return on their investment.1Accord-

ingly, good governance codes include system-

atic guidelines to guarantee eff‌iciency and

transparency in managerial actions to protect

free-f‌loat interests.

The Olivencia Report, published in 1998,

represented the f‌irst policy statement of its

kind in Spain, and closely aligned itself to pre-

vious similar European codes, particularly

the Cadbury Report (UK, December 1992).

Similar to the Cadbury Report, the Olivencia

Report echoed the concerns about the agency

problem between managers and shareholders

generated by the separation of ownership and

control, and included twenty-three best prac-

tice recommendations that highlighted the

roles of non-executive directors and monitor-

ing board committees. Although empirical

evidence both in the UK and the US supports

the argument that these good governance

*Address for correspondence:

Accounting and Finance

Department, Universitat Jaume

I, Campus del Riu Sec, Avgda.

Sos Baynat s/n. 12071,

Castellón (Spain). E-mail:

noguer@cof‌in.uji.es

THE EFFECT OF THE BOARD COMPOSITION AND ITS MONITORING COMMITTEES ON EARNINGS MANAGEMENT 1413

Volume 15 Number 6 November 2007

© 2007 TheAuthors

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Oxford, OX4 2DQ, UK and 350 Main St,Malden, MA, 02148, USA

mechanisms increase the general quality of

f‌inancial statements, some lingering doubts

remain as to the appropriateness of adopting

a code that closely benchmarks itself against

the UK model, since the Spanish legal tradi-

tion, quality of enforcement, investor protec-

tion and ownership structure are clearly

dissimilar. As pointed out by Recalde (2003),

Spanish companies have very different gover-

nance structures from their American or

UK counterparts, with important family and

institutional block holders that monitor man-

agers similarly to traditional owners, even if

a high degree of ownership dispersion

exists. Also, international accounting studies

have traditionally included Spain within the

group of civil-French law countries, charac-

terised by having weak investor protection

and enforcement regulations, and virtually

nonexistent litigation risk for directors and

auditors (e.g. La Porta et al., 1998, 1999; Leuz

et al., 2003).

To cast some light on these doubts, this

paper tests the association between the main

corporate governance mechanisms recom-

mended by the Olivencia Report and f‌inan-

cial statement quality, as measured by the

level of earnings management (EM).2We

analyse a sample of large Spanish quoted

companies that responded to a questionnaire

on their degree of compliance with the rec-

ommendations of the Olivencia Report in the

period 1999–2001. We focus on the areas that,

very much in line with the Cadbury Report,

were stressed in the Olivencia Report as

mechanisms to improve the quality of f‌inan-

cial statements: (1) optimal board composi-

tion, with the inclusion of a signif‌icant

number of non-executives, both institutional

and independent directors; and (2) the role of

board monitoring committees, in particular

the audit and nomination committees.

Following recent research, we use unsigned

discretionary accruals as the earnings

manipulation measure.

We f‌ind that the addition of institutional

directors to the board improves f‌inancial

statement quality, as denoted by a negative

relationship between unsigned discretionary

accruals and the proportion of institutional

directors on the board. However, the addition

of independent directors has proved to be an

ineff‌icient corporate governancemechanism in

our sample since a positive and signif‌icant

relationship is observed between earnings

manipulation measures and the proportion

of these directors on the board, with the

exception of situations where the f‌irm has a

nomination committee principally made up of

institutional directors. Moreover, we show

that reductions in the proportion of indepen-

dent directors on the board are associatedwith

a lower level of EM.

Our study contributes to the literature on

the association between corporate governance

and EM by testing how effective the gover-

nance recommendations introduced by codes

of best practice are at improving the quality of

f‌inancial statements in a continental European

setting, namely Spain. The usage of a continen-

tal European setting is particularly interesting,

as very limited previous research in this area

has been carried out. Some of our results coin-

cide with the f‌indings of previous research,

undertaken mainly in the US and the UK.

However, we also f‌ind some fundamental dif-

ferences, basically with regards to the role of

independent directors, who appear not to be

eff‌icient in carrying out their theoretical role in

constraining EM practices. The deeply rooted

differences between the legal and institu-

tional environments of common-law and civil-

French law countries probably explain why

the implementation of the same corporate gov-

ernance measures may result in signif‌icantly

different outcomes. Our results support the

opinion of some experts who claim that the

full application of an Anglo-Saxon corporate

governance model to the Spanish setting could

be inappropriate (e.g. Recalde, 2003). These

f‌indings have important policy implications

since the lack of effectiveness of the introduc-

tion of corporate governance recommenda-

tions in a country with no tradition of a market

of independent directors may enlighten

regulators to both the consequences of re-

commending f‌irms to voluntarily adopt

these measures and the need to implement

other measures that promote more profound

changes in the business culture.

The remainder of the paper is organised as

follows. Section 2 details the hypotheses based

on previous studies f‌indings and on the spe-

cif‌ic characteristics of Spanish f‌irms. Section 3

describes the sample. The methodology used

to measure EM and test the hypotheses is

detailed in section 4. Section 5 shows the main

results. In section 6 we comment on an addi-

tional analysis carried out, and f‌inally section 7

concludes.

2. Corporate governance

mechanisms and earnings

management

Based on previous research on the association

between good governance mechanisms and

EM, and taking into account the specif‌icities of

the Spanish context, in this section we develop

the hypotheses that are tested in the empirical

analysis. We focus on the two aspects of cor-

1414 CORPORATE GOVERNANCE

Volume 15 Number 6 November 2007 © 2007 TheAuthors

Journal compilation © BlackwellPublishing Ltd. 2007