The effect of distracted audit committee members on earnings quality

Abstract

In this paper, we examine the impact of distracting events to audit committee members on the firms’ earnings quality. Specifically, we focus on major events occurring simultaneously at other firms in which the audit committee members also serve as board members or CEOs. We find that during the years of major events, the number of board meetings at event firms significantly increases while there is no difference in board meetings at non-event firms. During this period, distracted directors miss more board meetings at the non-event firms than non-distracted directors. Consequently, firms with more distracted audit committee members have lower earnings quality. Our results indicate that director distractions, not director busyness, are associated with the decline in earnings quality. Notably, this decline in earnings quality at non-event firms is confined to the distraction years and audit committee members only. Our results have implications for shareholders and policy makers in assessing the tradeoffs between hiring experienced, qualified directors and the potential distractions that may result from their other commitments.

Appendices

Appendix 1: Definitions and sources of data used in this study

This appendix presents the definitions and sources of all variables used in this study

Director-firm-year variables

Variable	Definition	Source(s)
Attend less than 75% of board meetings	Indicator variable in the ISS RiskMetrics database	ISS RiskMetrics
Distracted director	Indicator variable equal to 1 if the director is experiencing a distracting event (lawsuit, merger, or acquisition) at another directorship	ISS RiskMetrics, Thomson Reuters SDC M&A, Securities Class Action Clearinghouse at Stanford University
Audit committee member	Member or chairman of the audit committee	ISS RiskMetrics
Director tenure	Number of years a director has served on the board	ISS RiskMetrics
Director age	Director age	ISS RiskMetrics
Director ownership	Percent of common shares outstanding held by the director, including fully exercised stock options	ISS RiskMetrics
Number of independent directorships	Number of total independent directorships held by the director within the ISS RiskMetrics dataset	ISS RiskMetrics
High-ranked directorship	Indicator variable equal to 1 if this directorship is at least 10% larger than the director’s smallest directorship as measured by market capitalization	ISS RiskMetrics

Firm-year variables

Variable	Definition	Source(s)
Absolute value of discretionary accruals	Modified–Jones model (see below)	Compustat
Distracted audit committee members (% of audit committee size)	Number of distracted audit directors divided by number of directors on audit committee	ISS RiskMetrics
Distracted independent directors (% of total independent directors)	Number of distracted directors divided by number of independent directors	ISS RiskMetrics
Distracted audit committee members (% of total independent directors)	Number of directors who are both distracted and on audit committee divided by number of independent directors	ISS RiskMetrics
Distracted non-audit committee members (% of total independent directors)	Number of directors who are both distracted and not audit committee members divided by number of independent directors	ISS RiskMetrics
Less than 50% of the audit committee is distracted	An indicator variable equal to one if at least one audit committee member is distracted but less than 50% of the audit committee is distracted.	ISS RiskMetrics
At least 50% of the audit committee is distracted	An indicator variable equal to one if at least 50% of the audit committee is distracted	ISS RiskMetrics
Number of board meetings	Number of times the board meets during the year	ExecuComp, Corporate Library
Post-SOX	Indicator variable equal to one if the fiscal year falls after 2001	Compustat
Ln (Assets)	Natural log of total assets (AT)	Compustat
Return on Assets (ROA)	Operating Income/Assets (variable OIBDP/AT in Compustat)	Compustat
Tobin’s Q	(Total assets − book value of equity + market value of equity)/Total Assets (AT − sum(SEQ, TXDB, ITCB, -PREF) + PRCC_C*CSHO)/AT	Compustat
Loss	Indicator variable equal to one if income before extraordinary items (IB) is negative	Compustat
Market leverage	(Long-term debt + Current debt)/(Total Assets − Book equity + Market cap) (DLTT + DLC)/(AT − CEQ + PRCC_F*CSHO)	Compustat
Board size	Number of directors on the board	ISS RiskMetrics
Percent independent directors	Number of independent directors on the board/Board size	ISS RiskMetrics
CEO ownership	Percent of common shares outstanding at fiscal year-end owned by the CEO	ExecuComp and Compustat
CEO tenure	Current year minus year became CEO	ExecuComp
CEO-Chairman duality	Indicator variable equal to 1 if the CEO also serves as Chairman of the board	ExecuComp
CEO bonus as % of total compensation	Bonus compensation as a percentage of total CEO compensation	ExecuComp
Option grants as % of outstanding shares	New option grants during the fiscal year scaled by total outstanding shares	ExecuComp
Unexercised exercisable options as % of outstanding shares	Number of unexercised options that have vested by fiscal year end, scaled by total outstanding shares	ExecuComp
Unexercised un-exercisable options as % of outstanding shares	Number of unexercised options that have not vested by fiscal year end, scaled by total outstanding shares	ExecuComp

Appendix 2: Modified Jones Model (Dechow et al. 2010)

For each 2-digit SIC industry group, we estimate Eq. (1) annually, requiring at least 8 observations for each industry-year combination and winsorize all of the regression variables at the 1% level.

$$\frac{{\left( {ibc - cfo} \right)_{i,t} }}{{at_{i,t - 1} }} = \beta_{1} \frac{1}{{at_{i,t - 1} }} + \beta_{2} \frac{{\Delta sales_{i,t} - \Delta rec_{i,t} }}{{at_{i,t - 1} }} + \beta_{3} \frac{{ppe_{i,t} }}{{at_{i,t - 1} }} + \varepsilon_{i,t}$$

(1)

Firm-specific discretionary accruals (DA) are computed as the residual from Eq. (1).

Variable	Definition	Compustat data item
ibc	Earnings before extraordinary items	ibc
cfo	Cash flow from operations	oancf − xidoc
at	Total assets	at
∆sales	Change in sales	sales
∆rec	Change in net receivables	rect
ppe	Gross property, plant, and equipment	ppegt