Audit committee characteristics and earnings management in New Zealand
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Recent corporate scandals at Enron, followed by WorldCom, Xerox, Royal Ahold, HealthSouth and similar others, put the spotlight on the effectiveness of corporate governance mechanisms in monitoring the financial reporting process. One specific area of concern is the monitoring function of the audit committee on earnings management. Prior research on audit committees and earnings management is based on relatively larger markets such as the U.S., UK and Australia. This study examines the association between audit committee characteristics and earnings management in a relatively smaller capital market such as New Zealand. New Zealand provides a unique context for this study because its legal and institutional environment is different from that of larger markets such as the U.S., UK and Australia. Her smaller size and reliance on the international economy, geographical isolation, and less regulated nature suggest that the findings based on larger markets may not be generalizable to New Zealand. Further, the New Zealand market is characterised by large concentrated ownership and directors serving on multiple boards. It is not clear how these unique characteristics affect the effectiveness of corporate governance. This study provides initial evidence on the association between audit committees and earnings management in New Zealand. Specifically, the study investigates the association between the likelihood of earnings management and (i) independence of the audit committee, (ii) expertise of the audit committee, (ii) shareholding of directors on the audit committee, and (iv) multiple directorships held by directors on the audit committee. The study also investigates the association between the New Zealand regulation on the audit committee and the likelihood of earnings management. The results of the study suggest an audit committee comprising majority independent directors reduces the likelihood of earnings management. A completely independent audit committee is not associated with the likelihood of earnings management. Greater proportion of directors with expertise, whether non-executive or independent, is associated with a lower likelihood of earnings management. However, the results suggest having one independent expert rather than one non-executive expert is associated with a reduction in the likelihood of earnings management. In relation to directors’ shareholding, the results suggest greater shareholding increases the likelihood of earnings management. There is some evidence that greater multiple directorships increases the likelihood of earnings management. Finally, the results relating to the New Zealand corporate governance regulation suggest an audit committee comprising majority independent directors and one independent expert reduce the likelihood of earnings management. This study fills an important void recognised by Bushman and Smith (1999) who call for governance research in smaller markets outside the U.S. to enhance our understanding of the legal and institutional impact on corporate governance. It provides the first evidence on audit committee and earnings quality in New Zealand, and therefore, has potential implications for regulations and policy makers in New Zealand. The findings of this research can also serve as a benchmark for studies in smaller countries with an institutional, economic, and legal environment similar to New Zealand.