Board of Director Effectiveness and Earnings Conservatism: Preliminary Australian Analysis

Abstract:The study’s overarching objective is to examine influence of board of director effectiveness on the extent of earnings conservatism amongst Australian listed firms. The study collected data from a sample of 100 Australian publicly listed firms stratified-randomly selected based on market capitalization to reduce size-biases. Data is collected for the 2008 financial year. Empirical results indicate more effective board of directors a more likely to incorporate negative news into earnings significantly faster (i.e., more timely) than less effective board of directors. This implies firms with more effective board of directors are more likely to report more reliable accounting information than firms with less effective board of directors. Additional analysis also shows that board of directors that are more independent, have independent members who are financially qualified and meet more frequently were more likely to be associated with disclosure of negative news in a more timely manner. However, results show board of directors composed of at least one independent director with prior committee experience were just as likely to report negative news in a similar time frame as board of directors without such experienced members.

1. Introduction and background

Conservatism is one of the principal foundations of financial accounting with a longstanding

and substantial influence.1 Empirical research indicates that conservatism has increased in the past

three decades (Balkrishna, Coulton, and Taylor, 2007; Givoly and Hayn, 2002; Givoly and Hayn,

2000; Huijgen and Lubberink, 2005; Krishnan and Visvanathan, 2007a). Despite the longevity and

reputed importance of conservatism, capital market regulators, accounting standard-setters and

scholars frequently criticize conservatism.2 The lengthy survival and resilience to criticism,

nonetheless, strongly suggests conservatism has significant benefits overlooked by critics.

Whilst there is a need to determine and understand the benefits of conservatism, there is also a

significant need to identify factors influencing conservatism. Identifying determinants of conservatism

is essential because though capital market regulators and accounting standard-setters may not directly

seek to eliminate conservatism, actions affecting the determinants of conservatism could have serious

indirect repercussions on financial reporting quality. The need to understand determinants of

conservatism has been amplified in the past decade following major corporate financial accounting

scandals. It has long been acknowledged corporate management have strong incentives to overstate

earnings (Fama, 1980; Jensen and Meckling, 1976). However, escalating pressures during the past

decade to meet investor and market expectations for higher revenues and earnings is thought to be

increasingly enticing corporate management to adopt more aggressive financial accounting practices.

Consequently, this undermines conservatism and the quality of earnings (LaFond and Watts, 2008).

A majority of prior research examining determinants of conservatism has concentrated on the

influence of institutional factors (Ball, Kothari, and Robin, 2000; Grambovas, Giner, and

Christodoulou, 2006; Lara, Osma, and Mora, 2005). Mounting attention to corporate governance

1 Conservatism is an open-ended phrase that is frequently used to refer to various concepts such as earnings conservatism and balance sheet conservatism. The author acknowledges the broad use of this phrase but within the specific context of this study, unless stated, conservatism is used purely from an earnings conservatism point of view. Other forms of conservatism, if used, will be prefixed by a leading word to describe the other form of conservatism.2 This is because the persistent asymmetric treatment of gains and losses is argued to lead to understatements in the current period that prompt the overstatement of earnings in future periods via the understatement of future expenditure.

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issues in the past decade has spurned a new stream of investigation examining the impact of corporate

governance mechanisms on conservatism. To date, much attention in this new stream has concentrated

on ownership structure, the auditing process, and audit firms and fees (Ahmed and Duellman, 2007;

Beekes, Pope, and Young, 2004; Hamilton, Ruddock, Stokes, and Taylor, 2005; Lafond and

Roychowdhury, 2008; Ruddock, Taylor, and Taylor, 2006). Other key corporate governance

mechanisms, pivotal to the financial accounting process, however, may likely be of significance but as

yet have received little, if any, attention. The board of directors is one such feature.

Board of directors have been placed at the centre stage of the global debate on corporate

governance reforms since the early 1990s (Blue Ribbon Committee, 1999; Corporate Governance

Committee, 2001; New York Stock Exchange and National Association of Securities Dealers, 1999).

Whilst boards of directors are acknowledged as the ultimate corporate governance mechanism for

monitoring the financial reporting process, responsibility for the general and day-to-day oversight is

increasingly delegated to the board of directors. The introduction of new corporate governance

regulations such as the ASX Corporate Governance Council Recommendations (ASX 2003) and the

Corporations Law Economic Reform Programme 9 (CLERP 9) have served to increase the

responsibilities and influence of board of directors in the financial reporting process.

Given the unprecedented and ever increasing interest in earnings by investors, combined with

escalating demands for higher quality earnings, there is an urgent need to identify influential factors

and the resulting impact on earnings. As discussed above, both the conservatism principle and the

board of directors are alleged to have a significant bearing on earnings (Beasley and Salterio, 2001;

Klein, 2002a; Watts, 2003). Currently the influence of a board of directors and its effectiveness on

conservatism (and ultimately earnings quality) remains an open empirical question that has not been

formally investigated. A pivotal aim of this study is to address this void in the extant literature

surrounding conservatism and the board of directors.

Studying board of director effectiveness/earnings conservatism linkage is important and

timely. Presently, international capital markets (including Australia) are highly volatile, raising

questions about earnings quality. Understanding the board of director effectiveness/earnings

conservatism link, and the impact on earnings quality, assists regulators derive strategies to restore

credibility in earnings. More generically, corporate governance is continuously under reform. Studying

the earnings conservatism/board of director effectiveness linkage, therefore, is of value as results will

determine whether there is a likelihood any changes to regulations governing board of directors will

impact on conservatism and earnings quality. Considering the earnings conservatism/board of director

effectiveness linkage in the context of Australia is also of interest. For example, corporate governance

has been a hot-bed of debate with the introduction of regulations such as ASX 2003 and CLERP 9. The

effectiveness and impact of these corporate governance reforms is still a matter of debate. Findings

from this study will aid in shedding new light and understanding on the debate. Also, the study focuses

on Australia because of the (a) paucity of existing research examining the relationship between board

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of directors and financial reporting quality in Australia, and (b) mixed empirical results to date using

data from this nation (Francis and Stokes, 1986; Goodwin, 2003; Stewart and Munro, 2007).

The primary objective of this study is to examine the association between board of director

effectiveness and earnings conservatism of Australian publicly listed firms. There is currently a lack of

consensus in the extant literature of a precise definition or factors determining board of director

effectiveness. Corporate governance advocates generally argue structural and operational composition

factors influence a board of director’s effectiveness. For example, in respect to structural composition,

Klein (2002a) argues more independent board of directors are effective in constraining managerial

opportunism, thereby, leading to greater quality of reported earnings. In the case of operational

composition, Abbott and Parker (2000a) and Abbott et al., (2003) state more diligent board of

directors (i.e., meet more frequently) are better able to address key financial reporting issues such as

earnings management and financial misstatement. In line with prior literature (Beasley and Salterio,

2001; Van der Zahn and Tower, 2004) this study focuses on four prime components underlying board

of director effectiveness: (a) sub-committee independence; (b) financial expertise; (c) experience; and

(d) diligence.

Overall, this study will benefit 1) firms in determining the optimal composition of board of

directors, 2) policymakers and investors by identifying the impact of board of director features; and 3)

regulators in determining the true role board of directors play in improving the level of earnings

quality reported by firms and therefore, the integrity of the financial reporting process. Finally,

findings from this study can be the basis of a more structured and systematic approach to board of

director formation and the ability of the board of director to uphold key regulatory reforms.

2. Literature Review and Hypotheses Development

Scholars have a lengthy history of supporting the importance of board of directors to the

financial accounting process including influencing earnings quality (e.g., Beasley and Salterio, 2001;

Pincus, Rusbarsky, and Wong, 1989). It is argued the central role of the board of director is to reduce

the magnitude of positive or negative abnormal accruals, thereby, enhancing earnings quality. The

board of director’s ability to accomplish any required and/or perceived roles and responsibilities in

monitoring the financial reporting process will depend primarily upon the sub-committee’s

effectiveness. Despite extensive debate there is little empirical research surrounding the issue of a

board of director’s effectiveness. Aside from studies focusing on earnings management, very few

empirical studies have sought to determine the influence of board of director effectiveness on other

aspects of financial accounting such as conservatism.

The conservatism concept is an effective governance mechanism. Watts (2003), for example,

suggests that the use of conservative accounting figures in contractual arrangements amongst various

parties associated with the firm reduces information asymmetry and moral hazard problems derived

from agency conflicts. A growing number of researchers (Ahmed and Duellman, 2007; Beekes et al.,

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2004; Lara et al., 2005) argue other corporate governance mechanisms may provide an additional layer

of conservatism important in determining earnings quality. Actions by regulators affecting corporate

governance mechanisms, therefore, could inadvertently affect conservatism and earnings quality.

2.1 Theoretical Perspective

Since Jensen and Meckling’s (1976) seminal work developing a theory of the firm based on

conflicts between contracting parties, a vast body of literature has developed explaining the nature of

the conflicts and means by which conflicts may be resolved. This theoretical perspective, commonly

known as agency theory, is strongly linked to earnings conservatism and board of directors’ role and

responsibilities. Watts (1992), for example, suggests conservatism likely evolved from accounting’s

contracting role. Watts (1992) argues accounting conservatism helps avoid inappropriate distributions

to claim holders. Basu (1997) suggests the conservatism principle evolved with audited financial

statements as a means of management bonding that prevents management exploiting information

asymmetry (a premise of Fama's 1980, agency theory). Ahmed et al., (2002) support the conservatism

and contractual arrangements link (and, in turn, agency theory). Specifically, Ahmed et al.,(2002)

argue conservatism mitigates conflicts of interest over dividend policy between shareholders and

bondholders. Finally, Watts (2003) expresses the view earnings conservatism is a component of

efficient contracting that restricts management’s opportunistic behaviour in contracting purposes. In

the case of board of directors, agency theorists strongly argue the board of directors is a pivotal

governance mechanism to mitigate conflicts between contractual parties. Carcello and Neal (2000), for

example, suggest a board of directors plays an important monitoring role. Beasley (1996), for

example, argues a board of directors is an effective monitoring mechanism in assuring the quality of

financial reporting and corporate accountability. This view is supported by others such as Carcello and

Neal (2000), Klein (2002a) and Van der Zahn and Tower (2004). Given the close association of

conservatism and board of directorss to contractual arrangements and agency conflicts, agency theory

provides the study’s underlying theoretical perspective.

2.2 Earnings Conservatism

Various renowned scholars (Ball and Shivakumar, 2005; Francis, LaFond, Olsson, and

Schipper, 2005; Watts, 2003) consider earnings conservatism a central indicator of earnings quality or

a desirable property of accounting earnings. Therefore, studies have examined the different aspects of

conservatism including existence, time series pattern, and determinants of conservatism (Basu, 1995;

1997; Givoly and Hayn, 2000; Lubberink and Huijgen, 2001; Givoly and Hayn, 2002; Penman and

Zhang, 2002; Lobo and Zhou, 2006; Ruddock et al., 2006; Givoly et al., 2007; Krishnan, 2007;

Krishnan and Visvanathan, 2007a; Roychowdhury and Watts, 2007).

The existence of earnings conservatism is strongly supported by the seminal study by Basu

(1997). After the groundbreaking findings of Basu (1997), Pae, Thornton and Welker (2005) found

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that earnings were conservative in all periods examined. Similarly, Balkrishna, Coulton and Taylor

(2007b) sought to provide evidence of earnings conservatism in the financial reporting practices of

Australian firms. Apart from providing evidence about the existence of earnings conservatism, some

studies (Basu, 1997; Givoly and Hayn, 2000; Givoly and Hayn, 2002; Huijgen and Lubberink, 2005;

Lobo and Zhou, 2006; Balkrishna, Coulton and Taylor, 2007a; Krishnan, 2007) sought to examine the

time-series pattern of earnings conservatism and concluded that earnings conservatism has increased

over time (Basu, 1997; Givoly and Hayn, 2000; Givoly and Hayn, 2002; Huijgen and Lubberink,

2005; Lobo and Zhou, 2006; Balkrishna et al., 2007a; Krishnan, 2007).

Prior research on earnings conservatism has also identified a number of determinants which

influence earnings conservatism (Ball et al., 2000a; Gigler and Hemmer, 2001; Easton and Pae, 2004;

Gassen et al., 2006a; O'Connell, 2006; Qiang, 2007a; Lafond and Roychowdhury, 2008). The

determinants can be classified into three broad categories: (1) firm characteristics (2) institutional

factors and (3) governance structures.

In relation to firm characteristics, Easton and Pae (2004) found evidence that change in cash

investment provided significant incremental explanatory power for returns over earnings and earnings

changes. Similarly, Pae et al. (2005) showed that earnings conservatism was substantially greater in

portfolios of firms with lower price-to-book ratios than in portfolios of firms with higher price-to-book

ratios. Kwon, Yin and Han (2006), further indicated that distribution of earnings and discretionary

accruals between the two groups of firms were consistent with a higher level of accounting

conservatism evident in high-tech firms vis-à-vis low-tech firms. In addition, Pae (2007) found that

conditional accounting conservatism was attributable mainly to unexpected accruals suggesting that

managers exercise discretion over accruals to expedite the recognition of bad news rather than good

news.

Prior research has concluded that institutional factors such as accounting polices and

regulation, legal regimes (i.e. code law versus common law), political influence and cross-listing of

firms in different jurisdictions have a significant impact on the level of earnings conservatism reported

by firms (Pope and Walker, 1999; Huijgen and Lubberink, 2005; Lara et al., 2005; Brown Jr. et al.,

2006; Bushman and Piotroski, 2006). Ball, Kothari and Robin’s (2000b) results indicated that

common-law accounting income did exhibit greater timeliness than code-law accounting income. Pope

and Walker (1999), for example, concluded that the US accounting regime was significantly more

conservative than the UK regime, when comparing earnings before extraordinary items. Similarly,

Huijgen and Lubberink (2005) found that earnings of UK cross-listed firms (in the US) were

significantly more conservative than earnings of UK firms without a US listing. In addition, Lara et al.

(2005) reported that in certain institutional contexts (that is, weaker investor protection and less

dispersed ownership structures), earnings management drove the measures of conservatism. Finally,

Bushman and Piotroski (2006) found that investor protections embodied in corporate law and the

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efficiency and impartiality of the judicial system played a significant role in creating incentives for

timely loss recognition.

Recent studies highlight the link between earnings conservatism and corporate governance

structures. Beekes, Pope and Young (2004) found that firms with a higher proportion of outside

members are more likely to recognize bad news in earnings. Similarly, Ahmed and Duellman (2007)

discovered a negative relationship between the percentage of the inside directors on the board and

earnings conservatism. They (Ahmed and Duellman, 2007) also found a positive relationship between

the ownership percentage of outside directors and earnings conservatism. Similarly, Lafond and

Roychowdhury (2008) concluded that firms with lower managerial ownership report more

conservative earnings. Ruddock et al., (2006), meanwhile, stated that the provision of non-audit

services is positively associated with a reduction in the extent to which earnings reflect bad news on a

more timely basis than good news (i.e., earnings conservatism). Finally, Hamilton, Ruddock, Stokes

and Taylor (2005) found a significant increase in the asymmetrically timeliness of economic losses

when a firm changes an audit partner.

Of various corporate governance mechanisms discussed in the popular press and scholarly

research during the past decade, board of directors have been a central focus in debates about how to

assure and enhance the quality of financial reporting and corporate accounting. Despite the

acknowledged role of the board of director, studies have yet to consider the relationship to earnings

conservatism. Research does, however, provide evidence of the linkage between board of directors and

earnings quality. Various incentives exist to suggest why a board of directors is motivated to ensure

the credibility of the financial reporting process and that quality of earnings is preserved. For example,

independent directors on the board of directors have a strong incentive to ensure the sub-committee’s

roles and responsibilities are fulfilled so as to ensure their (i.e., the independent directors) reputational

capital and opportunities for appointment to other boards. As high quality earnings will likely be

perceived as a key benchmark of a board of director’s success and reputation (and that of its

members), this provides strong motivation for the sub-committee to undertake actions that enhance

earnings quality. As noted earlier, greater earnings conservatism is thought to enhance earnings

quality. Consequently, it follows that a board of directors will actively engage in conservative earnings

practices with the aim of improving earnings quality.

Despite incentives to engage in greater earnings conservatism, the mere presence of the board

of directors does not automatically mean such practices will be undertaken. Rather, as highlighted in

the extant literature, the effectiveness of the board of directors will determine whether the sub-

committee actively seeks to conserve earnings or not. A more effective board of directors will be

better able to mitigate opportunities for corporate management to engage in opportunistic behaviour

that can affect earnings quality. Furthermore, a more effective board of directors will have greater

ability to override aggressive financial accounting policy choices initiated by corporate management

that could promote less conservative earnings results. Finally, if a board of directors is more effective

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in its arbitration role, this will aid in the development of more systematic compromises between

corporate management and external parties (such as the external auditor). Improved resolution of

conflicts, therefore, will likely enhance the acceptance of conservative earnings practices. Based on

the above discussion, therefore, the general hypothesis tested is postulated as:

GH: Australian publicly listed firms with more effective board of directors are more likely to have higher levels of earnings conservatism.

2.3 Components of Board of Director Effectiveness and Influence on Conservatism

There are four main categories of board of director effectiveness determinants are identified

as: (1) arrangement (i.e., sub-committee independence, size and duality); (2) resources (i.e., financial

expertise, committee experience); (3) authority (i.e., power enshrined in the sub-committee); and (4)

diligence (i.e., active meeting of sub-committee).3 The first two categories relate to structural

composition whilst the latter two to operational composition features. Whilst postulated above that

overall board of director effectiveness is positively associated with earnings conservatism, different

components underlying a board of director’s effectiveness could have differing degrees of influence.

This study is extended to examine this proposition with, hypotheses developed below in respect to four

key components (i.e., independence, financial expertise, prior experience and diligence) frequently

cited as central determinants of board of director effectiveness.

2.3.1 Board of Director Independence

Corporate governance advocates, regulators and scholars frequently argue a board of directors

with a higher proportion of outside directors is less likely to be compromised in undertaking the sub-

committees roles and responsibilities. Furthermore, a more independent board of directors is likely to

be better able to constrain opportunistic behavior of corporate management. Empirical findings have

generally supported the perception an independent board of directors is more effective in constraining

corporate management and improving earnings quality. Van der Zahn and Tower (2004), for example,

observed a significant positive relationship between earnings management and board of directors with

less than a majority of outside directors. Meanwhile, others have determined board of directors

comprising solely of non-related directors had a positive association with the quality of the firm’s

financial reports. McMullen and Raghunandan (1996) also found that firms with reporting problems

were less likely to have board of directors composed solely of outside directors. Similarly, Abbott and

Parker (2000b) concluded that firms with more independent directors were less likely to be sanctioned

by the SEC for fraudulent or misleading financial reporting compared to firms whose board of

directors did not comprise of independent directors. Additionally, it is reported fraudulent firms had

less independent board of directors than no-fraud industry benchmarks. Overall, prior theoretical and 3 There is currently no consensus on a definition of audit committee effectiveness. Rather, a number of determinants have been detailed in the extant literature that researchers propose affect the effectiveness of the audit committee. DeZoort et al.,(2002), for example, suggest that audit committee effectiveness occurs when audit committees comprise qualified members who have the authority and resources to protect stakeholder interests by ensuring reliable financial reporting, strong internal controls and comprehensive risk management practices through diligent oversight efforts.

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empirical research provides a sound foundation to imply that independent board of director members

are more likely to (perhaps) require the recognition of bad news sooner and delay the reporting of

good news (i.e., actions that support earnings conservatism) in order to protect their reputational

capital, reduce contracting and mitigate litigation costs. Thus, more independent board of directors are

likely to support more actively actions promoting earnings conservatism. To test this assertion, the

following hypothesis is proposed:

H1: Australian publicly listed firms with a majority of independent directors on the board of director are more likely to have higher levels of earnings conservatism.

2.3.2 Board of Director Financial Expertise

As new corporate governance regulations continue to expand a board of directors’ role and

responsibilities, there is growing pressure on members to develop greater financial expertise to counter

the escalating complexity and sophistication of the financial reporting. Theoretical and applied views

have been forwarded in the extant literature suggesting greater financial expertise amongst board of

director members enhances effectiveness. McDaniel, Marint and Maines (2002) argue the presence of

a financial expert improves the quality of the firm’s financial statements. DeZoort, Hermanson and

Houston (2003) state financial experts provide greater resolve to support the external auditor during

auditor-management disagreements. Abbott, Parker and Peters (2004), meanwhile, argue greater

financial expertise is better in preventing occurrences of financial misstatements. Finally, Defond et

al., (2005) suggest greater financial expertise enhances the firm’s overall internal control. Empirical

research has generally supported the notion the board of directors’ effectiveness is enhanced with the

presence of a financial expert (or experts) as a member (e.g., Van der Zahn and Tower, 2004).

Therefore, the following hypothesis is proposed to test this assertion:

H2: Australian publicly listed firms with board of directors comprising members with financial expertise are more likely to have higher levels of earnings conservatism.

2.3.3 Board of Director Experience

Corporate governance experience of board of director members is cited by regulators,

corporate governance advocates and scholars as a major factor determining the board of directors’

effectiveness (Blue Ribbon Committee, 1999). Empirical evidence has supported these views. Dezoort

(1998), for example, observed experienced directors made more consistent judgements, had better

self-insight and higher technical content levels. He (Dezoort, 1998) concluded this signified

improvements in effectiveness. Research has found board of director members with greater corporate

governance experience were more likely to support the auditor in an auditor-management conflict, and

more likely to address and detect material misstatement. Again, experience is seen to have a positive

influence on board of director effectiveness. Finally, Carcello and Neal (2003) found directors who sat

on other board of directors (i.e. governance expertise) were more effective in protecting the auditor

from dismissal following the issuance of a going concern report. Based on theoretical arguments and

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empirical findings, it is expected board of directors with more experienced members will be more

effective in ensuring firms adopt appropriate conservative earnings practices relative to firms with less

experienced board of director members. The following proposed hypothesis tests this assertion:

H3: Australian publicly listed firms with board of directors comprising members with prior governance experience are more likely to have higher levels of earnings conservatism.

2.3.4 Board of Director Diligence

It is strongly argued in the extant literature (Abbott et al., 2004; Bedard et al., 2004; Menon

and Williams, 1994; Xie, Davidson, and DaDalt, 2003) that an effective board of directors meets

regularly; thus, is more capable of ensuring the financial reporting process is functioning properly. A

more active board of directors is thought to be able to detect and prevent opportunistic behaviour by

management and to ensure the integrity of reported earnings. Past research indicates the board of

directors of fraud firms met less often than board of directors in firms not experiencing fraud.

Similarly, firms with board of directors meeting at least biannually were less likely to be sanctioned by

the SEC for financial reporting problems. Others such as McMullen and Raghunandan (1996), Abbott

et al., (2004) and Vafeas (2005) find firms with reporting problems had less frequent meetings. Xie et

al., (2003), meanwhile, find the number of board of director meetings is negatively associated with

discretionary current accruals implying diligence is an important factor in constraining the

management’s propensity to manage earnings. Finally, Krishnan and Visvanathan (2007b) show that

board of directors meeting more regularly were more likely to detect internal control weaknesses.

Prior literature considering board of director diligence literature clearly demonstrates the

importance of having sufficient board of director meetings per year and its impact on the financial

reporting process. Based on the prior empirical findings, therefore, it is likely more diligence board of

directors will be better able to ensure the adoption of conservative earnings practices to ensure greater

earnings quality. To formally test this assertion, the following hypothesis is forwarded:

H4: Australian publicly listed firms with more diligent board of directors (i.e., meet more frequently) are more likely to have higher levels of earnings conservatism.

3. Sample and Method

3.1 Selection and documentation

Data for this study is obtained from a number of sources. Data for the earnings conservatism

measure is obtained from two different databases. Accounting data is collected from FinAnalysis

whilst stock return data is obtained from DataStream. Data for the main independent variable, board

of director effectiveness (i.e. AC) comprising four primary sub-components (e.g., board of director

independence, financial expertise, experience and diligence), is hand collected the 2008 financial year

annual report of firms included in the sample.4 The annual reports were obtained from the Annual 4 In financial (or fiscal) year in Australia runs from July 1 to June 30 of the following calendar year. For ease of administration this study sought to align the financial year as close as possible with the calendar year. Consequently, a firm’s annual report is defined to be from the 2008 financial year if the firm’s end of financial year is between April 1, 2008 and March 31, 2009. Of the final useable sample on nine [9] firms had financial year ending on dates other than June 30, 2008. Eight [8] firms had December 31, 2008 year ends and one [1] firm had an August 31, 2008 year end.

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Reports Collection (Connect 4 Pty Ltd). Where annual reports were not available from the Annual

Reports Collection (Connect 4 Pty Ltd) database the documentation was from DatAnalysis or direct

from the firm.

Analysis involves an examination of a sample of 100 stratified-randomly firms listed on the

Australian Stock Exchange (ASX) during the 2008 calendar year.5 The initial sample comprises all

publicly listed firms listed on the ASX as at January 1, 2008. Consistent with prior research, financial,

banking, insurance and utilities are excluded from the sample (Ball et al., 2000a; Givoly and Hayn,

2000; Goodwin, 2003; Ruddock et al., 2006; Givoly et al., 2007). Firms not continuously listed on the

ASX during the observation period (specifically IPO firms and firms de-listed for a period of time and

re-listed) are also excluded in order to avoid undue influences of unexpected share price changes.

Consistent with Clifford and Evans (1997), foreign firms domiciled outside Australia are also

excluded since their (foreign firms domiciled outside Australia) financial statements are not always

prepared in accordance with the normal disclosure requirements for other firms listed on the ASX.

Firms that have an indication of missing data during the observation period are also excluded (Klein,

2002b) leaving a sample pool of 1,628 firms.

From the resulting sample pool of 1,628 firms, 100 are randomly selected using a stratified-

random approach which involves stratifying each year into quartiles by market capitalization and

randomly selecting a sample of 25 firms within each quartile (Balvers et al., 1990). 6 However, from

the final sample of 100 firms, 6 firms are further excluded given incomplete information leaving a

final usable sample of 94 firms. Table 1 Panel B presents the industry breakdown of the sample firms.

Industrials and materials collectively represent the highest proportion of final sample firms by

industry. This representation is proportionally representative of the market as a whole. Thus, each

industry contains enough observations to control for the industry effects in the regression.

[Insert Table 1 About Here]

3.2 Measurement of Earnings Conservatism

Prior research suggests earnings conservatism can be conceptualized in several different ways.

Three dominant views detailed in the literature perceive earnings conservatism as being a function of

either: (a) timeliness, (b) persistence or (c) differences in current period accruals and cash flows (Basu,

1997; Ruddock et al., 2006; Watts, 2003). A comprehensive analysis of earnings conservatism and the

three major perceptions of this concept such be undertaken to develop a more definitive picture. Such

5 Results reported in this study are preliminary results for a larger longitudinal study. The longitudinal study covers a five calendar year period (January 1 2004 and December 31 2008). The five-year period is selected to minimize any significant extraneous influences on findings as a result of fallout from the ‘Dot.Com Bubble’, the introduction of new International Financial Reporting Standards ( IFRS) and excessive volatility due to the 2009 Global Financial Crisis. The period for the broader longitudinal study is also selected as it transcends the introduction of key corporate governance reforms in Australia (i.e., CLERP 9 and ASX 2003). Findings from this study may indicate whether recommendations related to audit committees in CLERP 9 and ASX 2003 impact the audit committee effectiveness/earnings conservatism linkage. Due to time constraints the current paper focuses on only a single year. In future versions the full study analysis will be reported.6 Since one of the major drivers of firm performance is the need to maximize shareholder value, this measure is best reflected by the firm’s market capitalization. For this study firms will be the same for each of the calendar years examined. This raises a possible independence issue. However, it is not considered detrimental to the study because: (a) it only applies to the longitudinal OLS regression models to be used and (b) almost all of the past literature (in both accounting and finance fields) using firm-year observations for multivariate testing accept the fact that independence of samples may be of concern but that there is no other parsimonious way to undertake such length-of-time analysis where the changes in selected firm’s results are of interest to the researcher/s.

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analysis is undertaken in additional work not reported in this current paper due to time constraints.

Hence, for purposes of this initial exploratory study analysis focuses solely on the timeliness of

conservatism. To measure the timeliness of earnings conservatism the methodology developed by

Basu (1997) is used. Equations 1details the basic model underlying Basu’s (1997) measure of the

timeliness of earnings conservatism:

Xjt = α0 + α1DRjt + β0Rjt + β1DRjt*Rjt + εjt [1]Where:

Xjt = Operating profit after tax of firm j deflated by market value of equity (MVE t-1 - Market value of equity of firm j at beginning of the fiscal year t) of firm j at beginning of the fiscal year t;Rjt = Buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j;DRjt = Indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0);DRjt*Rjt = Two-way interaction between indicator variable where firm j is scored one (1) if Rjt

is negative, otherwise firm j is scored zero (0) and the buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j;αk, βk = Coefficients; andεjt = Error term.

Basu’s (1997) timeliness model of earnings conservatism (i.e., Equation 1) presumes losses are

recognized more quickly than gains so share prices reflect bad news in contemporaneous market losses

earlier than good news via market gains..

3.3 Measurement of Board of Director Effectiveness

Presently there is no consensus on a precise measure for board of director effectiveness.

Following prior work (Beasley and Salterio, 2001; Klein, 2002a, 2002b; Van der Zahn and Tower,

2004), this study develops a composite score for board of director effectiveness based on the sub-

committees independence, expertise, experience and diligence. Specifically, for firm j in time period t,

a composite score for board of director effectiveness (henceforth denoted BoDjt) is based on a score of

one (1) being awarded for each of the following individual characteristics being met:

The board of director of firm j in time t consists of a majority of independent directors; At least one independent board of director member of firm j in time period t is a qualified

person with accounting expertise possessing necessary educational qualifications (i.e., degree in accounting) and professional credentials (i.e., member professional accounting body) and/or work experience as a chief executive officer in a non-for-profit organization7;

At least one independent member of the board of director of firm j in time period t has prior experience on the board of director of another firm; and

The board of director of firm j met 4 or more times during the time period t.

7 In order to effective manage the finances of a non-for-profit organization a chief executive officer will need to be financially literate and component with a major understanding of financial accounting and auditing issues. Publicly listed firms may desire individuals with a non-for-profit background to fill the role of an independent director so as to enhance to concept of ‘independence’.

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The range of scores for BoDjt, therefore, is zero (0) to four (4). For additional analysis, BoDjt is

decomposed into four measures representing each individual component. Specifically, the measure

for: (a) board of director independence is denoted as Ind_BoDjt; (b) board of director expertise is

denoted as Expt_BoDjt; (c) board of director experience is denoted as Exp_BoDjt; and (d) board of

director diligence as Dil_BoDjt. Each individual board of director effectiveness component metric is

scored as per the respective criteria outlined in scoring BoDjt. Data to calculate respective board of

director effectiveness measures is obtained from annual reports of firms selected in each firm year.

The calculation can be represented mathematically in Equation 2 as:

BoDjt. = ∑ (Ind_BoDjt + Expt_BoDjt + Exp_BoDjt + Dil_BoDjt) [2]Where:

BoDjt = Composite audit committee effectiveness score of firm j in fiscal year t;Ind_BoDjt = Indicator variable that takes the value of 1 if the majority of the board of directors of firm j in time period t are independent directors, and 0 otherwise;Expt_BoDjt = Indicator variable that takes the value of 1 if at least one independent director of the board of directors of firm j in time period t has necessary expertise (based on educational, professional affiliations and/or non-for-profit role) to be financially qualified, and 0 otherwise;Exp_BoDjt = Indicator variable that takes the value of 1 if at least one independent director of the board of directors of firm j in time period t has prior board of director experience, and 0 otherwise;Dig_BoDjt = Indicator variable that takes the value of 1 if the board of directors of firm j in time period t met four [4] or more times during time period t, and 0 otherwise;

3.4 Statistical Analysis

To formally test the general hypothesis, Equations 1 is extended to incorporate intercept and

slope coefficients for the interactive effects of a board of directors’ effectiveness. The test model is

defined by Equations 3:

Xjt = α0 + α1DRjt + α2BoDjt + α3DRjt*BoDjt + β0Rjt + β1Rjt*DRjt + β2Rjt*BoDjt + β3Rjt*DRjt*BoDjt

+ εjt [3]Where:

Xjt = Operating profit after tax of firm j deflated by market value of equity (MVE t-1 - Market value of equity of firm j at beginning of the fiscal year t) of firm j at beginning of the fiscal year t;DRjt = Indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0);BoDjt = Composite board of director effectiveness score of firm j in fiscal year t;DRjt*BoDjt = Two-way interaction between indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0), and the composite board of director effectiveness score of firm j in fiscal year t;Rjt = Buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j;Rjt*DRjt = Two-way interaction between the buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-

1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j and indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0);Rjt*BoDjt = Two-way interaction between the buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and

12 | P a g e

Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j and the composite board of director effectiveness score of firm j in fiscal year t;Rjt*DRjt*BoDjt = Three-way interaction between the buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j, indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0), and the composite board of director effectiveness score of firm j in fiscal year t; αk, βk = Coefficients; andεjt = Error term.

In determining the influence of board of director effectiveness (and individual components) on

earnings conservatism, the sign and significance of the coefficients on β2 and β3 are considered. If

higher board of director effectiveness is associated with firms reporting conservative earnings on a

timely basis, then the β2 and β3 coefficients in tests of Equation 3 should be positive and significant.

Positive and significant β2 and β3 coefficients would indicate greater asymmetric timeliness in the

recognition of good and bad news.

4. Main Findings

4.1 Descriptive statistics

Table 2 contains the descriptive statistics. For the pooled-sample Table 2 results indicate

average operating income (OPATjt) declined 62.277% during the 2008 financial year. Average and

median for 2007 and 2008 financial year operating income values (i.e., OPATjt-1 and OPATjt) for firms

in the 1st Quartile and 2nd Quartile (3rd Quartile and 4th Quartile) are positive (negative). Average

operating income for the 1st Quartile and 4th Quartile decreased year-on-year (i.e., 2007 financial year

compared to 2008 financial year) but interesting increased for firms in the 2nd Quartile and 3rd Quartile.

Declines in operating income can likely be attributed to the tough economic conditions that developed

during the 2008 calendar year that culminated in the Global Financial Crisis.8

Consistent with Lara et al. (2009), Table 2 shows that median value of deflated earnings (Xjt)

for the pooled-sample is greater than the mean (i.e., 0.003 compared to -0.032). This indicates

earnings for the pooled-sample is negatively skewed. However, when the pooled-sample is partitioned

by quartiles, earnings are negatively skewed (median values exceed mean values) for the 1 st Quartile

and 4th Quartile (i.e., largest and smallest firms by market capitalization). Earnings are positively

skewed (mean values exceed the median values) for 2nd Quartile and 3rd Quartile; this result which is

consistent with Ruddock et al. (2006).

8 The roots of the Global Financial Crisis and the associated global recession (though unlike the majority of developed and emerging economies worldwide Australia never entered recession) can be traced to October 2007 though the most severe ramifications (particularly in respect to stock and commodity markets) did not take hold till the 3 rd and 4th quarters of 2008. Economic growth (Gross Domestic Product) was steady during the 3rd and 4th quarters of 2007 (i.e., 4.2%) before decline in subsequent quarters in 2008 (i.e., 3.40% 1st Quarter, 3.00% 2nd

Quarter, 2.40% 3rd Quarter and 0.70% 4th Quarter). The decline in operating profits likely reflects the slowing growth of the global and domestic markets during 2008. The operating year for the majority of the final useable sample firms is from July 1, 2007 to June 30, 2008; hence, 3rd Quarter 2007 to 2nd Quarter 2008. Thus, whilst operating income decline on average, the annual results for the majority of firms were derived prior to the true impact of the Global Financial Crisis taking hold.

13 | P a g e

In line with the decline in average operating income, the average market capitalization of the

pooled-sample decline year-on-year (i.e., MarCapjt-1 and MarCapjt) by 17.112%. Declines in market

capitalization are across each quartile sub-sample. The decline is highest (least) amongst firms in the

1st Quartile (2nd Quartile). Relative to the market, firms of the final useable sample underperformed as

indicated by the negative sign on the average RR-All Ordjt value for the pooled-sample.9 Whilst firms

in the 2nd, 3rd and 4th Quartiles by market capitalization underperformed the general market, firms of

the 1st Quartile outperformed the market on average. Overall, 57 firm (or 60.638%) of the final useable

sample suffered negative market-adjusted 2008 financial year returns. Of firms in the 1 st Quartile only

11 (or 45.833%) had negative market-adjusted 2008 financial year returns whilst 18 (or 75.000%) of

those in the 4th Quartile had negative market-adjusted 2008 financial year returns. RR-All Ordjt and

DRjt results by quartile suggest smaller firms on the ASX were likely to have suffered greater stock

declines for the 2008 financial year than larger counterparts.

[Insert Table 2 About Here]

The average size of the board of directors of the pooled-sample (i.e., 5.470) is relatively (or

perhaps slightly lower) than reported in other countries such as the United States, United Kingdom and

Singapore. Consistent with prior research in Australia and abroad, the size of the board of directors

tends on average to be smaller when the size of the firm declines. Independent directors accounted on

average for 47.763% of the members of the board of directors of firms in the pooled-sample. Firms in

the 1st Quartile (4th Quartile) had the highest (lowest) average percentage of independent director

representation on the board of directors. In total 50 (or 53.191%) firms in the pooled-sample had board

of directors comprising a majority of independent directors (see Ind_BoDjt). Nearly all 1st Quartile

firms had board of directors with a majority of independent directors whilst only eight [8] firms in the

4th Quartile had a majority.

As argued above an independent director is deemed to have financial accounting expertise if

possessing necessary accounting education qualifications and professional affiliations, or is (has) been

employed as a chief executive officer of a non-for-profit organization. Table 2 results show

approximately a quarter (i.e., 24.439%) of the independent directors on the board of directors of

pooled-sample firms had accounting expertise based on accounting qualifications and professional

affiliations (see Expt_Acc_BoDjt). As expected firms in the 1st and 2nd Quartiles had the highest

percentage of a board of directors comprising independent directors with relevant financial accounting

qualifications and professional affiliations. Overall, 69 (or 73.404%) firms in the pooled-sample had

at least one independent director on the board of directors with financial expertise based on accounting

education and/or professional affiliation credentials (see Expt_Acc_BoDjt). In contrast, 32 (or

34.043%) of the pooled-sample had at least one independent member on the board of directors who 9 There is considerable debate in the literature on the appropriate market index to be used in calculating market-adjusted returns. Values reported in Table 2 are based on use of the All Ordinaries Index for purposes of market-adjustment. The All Ordinaries Index is a relatively broad industry based market measure but is generally comprised of larger firms. Returns using alternative market indices to compensate for size and industry biases were also calculated. Sensitivity tests (as reported in Table 3) were performed using the alternative return measures.

14 | P a g e

had prior or existing chief executive officer experience with a for-profit organization (see

Expt_CEONP_BoDjt). Firms in the 1st and 2nd Quartiles had the highest percentage of firms having at

least one independent director on the board of directors who had prior or existing chief executive

officer experience with a non-for-profit organization. In total 75 (or 79.787%) of the pooled-sample

are found to have at least one independent director on the board of directors who is deemed to be

financially qualified (see Expt_BoDjt).

Table 2 results indicate that on average 41.943% of the members of the board of directors of

pooled-sample firms are independent directors with prior board of director experience (see

%AC_Exp_BoDjt). As per other board of director characteristics and effectiveness traits, board of

directors of firms in the 4th Quartile had the lowest average of board of directors composed of

independent directors with prior board of director experience (i.e., 50.000%) with firms in the 3 rd

Quartile having the highest average (i.e., 100.000%). Overall, 62 (or 65.957%) of the pooled-sample

had at least one independent on the board of director with prior board of director experience (see

Exp_BoDjt).

The pooled-sample’s average number of board of director meetings (i.e., 10.710) is

comparable to that reported for US firms (e.g., Abbott et al., 2004) and those firms in neighbouring

Asian nations (e.g., Van der Zahn and Tower, 2004). Table 2 results indicate a distinctive division in

the number of board of director meetings held by larger and smaller firms. Specifically, 1 st and 2nd

Quartile firms met (on average) three times more during the year than counterparts in the 3 rd and 4th

Quartiles (i.e., 11.380 and 12.170 meetings compared to 9.320 and 9.880 meetings). Overall, 54 (or

57.447%) of the firms in the pooled-sample met ten [10] or more times during the year.

Finally, the pooled-sample’s average (median) board of director effectiveness score (i.e.,

BoDjt) is 2.330 (3.000). If using two [2] as an arbitrary benchmark for defining average effectiveness

then the majority of firms in the pooled-sample had above average effective board of directors.

However, as potentially expected, board of directors of larger firms scored higher on average for their

effectiveness. This result may be explained by larger firms having more resources available to ensure

board of directors have members that better contribute to the committee’s effective. Alternatively, in

line with agency theory, larger firms may have more at stake (e.g., reputation) than smaller firms.

Consequently, larger firms are more politically visible than smaller counterparts, and will have greater

incentive to ensure the effectiveness of the board of directors.

4.2 Regression results

Table 3 presents the initial results testing the association between earnings conservatism and

board of director effectiveness. Results in Table 3 Column I report the basic association between

earnings and annual returns without consideration for other compounding influences. The coefficient

on Rjt is positive and highly significant (p<0.01). This result is inconsistent with other related

Australian earnings conservatism research (e.g., Taylor and Taylor, 2003; Hamilton et al., 2005) but in

line with recent European studies (e.g., Lara et al., 2007; Kankaanpaa, 2008). The inconsistency with

15 | P a g e

prior Australian earnings conservatism could be the result of temporal differences in datasets or the

relatively low sample size in this study that may not provide an (as yet) comprehensive picture cross-

section of Australian firms. When additional explanatory factors are introduced into the model (see

Table 3 Column II and Column III), the coefficient on Rjt continues to be positive. The coefficient,

however, is only moderately significant (p<0.10) in Basu’s (1997) basic base model specification (see

Table 3 Column II) when the indicator variable DRjt and two-way interaction term Rjt*DRjt are

included.

[Insert Table 3 About Here]

In the test of Basu’s (1997) basic base model (see Table 3 Column II) and the study’s full

model (see Table 3 Column III) the coefficient on DRjt is positive and significant (p<0.10).

Meanwhile, the coefficient on the two-way interaction term Rjt*DRjt is negative and statistically

significant in tests of Basu’s (1997) basic base model (see Table 3 Column II) and the study’s full

model (see Table 3 Column III). Findings related to the two-way interaction term Rjt*DRjt is consistent

with prior research suggesting that existence of earnings conservatism across all firms in the sample.

The result also indicates that negative news is conveyed more swiftly to the market than good news

(Lara et al., 2007).

In Table 3 Column III Basu’s (1997) basic base model of the timeliness of earnings

conservatism is extended to include the board of director effectiveness measure and relevant

interaction terms. The coefficient on BoDjt is positive and significant (p<0.01) suggesting firms with

more effective board of directors were associated with better earnings. Meanwhile, the coefficient on

the two-way DRjt*BoDjt variable is negative and significant (p<0.05). One of the two variables of

prime interest to this study is defined by the two-way Rjt*BoDjt variable. Table 3 Column III results

indicate the coefficient on the Rjt*BoDjt variable is negative and significant (p<0.01). The significant

negative result implies that firms with a more effective board of directors appears to recognize

negative news faster than counterparts with less effective board of directors. With respect to the main

variable of interest – defined by the three-way Rjt* DRjt*BoDjt interaction variable – the coefficient is

positive and significant (p<0.01). The result related to the Rjt* DRjt*BoDjt interaction variable

reinforces the proposition firms with more effective board of directors report more conservative

earnings figures.

To further explore the association between board of director effectiveness and earnings

conservatism the main regression model (as defined by Equation 3) is performed again but with the

individual components of board of director effectiveness respective replacing the composite score.

Results from the additional tests are reported in Table 4.

[Insert Table 4 About Here]

Consistent with Table 3 results the coefficient on Rjt is positive and significant (p<0.01 or

p<0.10) in three of the four regressions reported in Table 4. Interestingly, the coefficient on Rjt is

positive but insignificant when testing for the association between the prior board of director

16 | P a g e

experience of independent directors on the committee and earnings conservatism (see Table 4 Column

III). Similar to the Rjt results, the coefficients on the DRjt and Rjt*DRjt variables are positive across the

four regressions reported in Table 4. However, the coefficients are only significant in regressions

testing the specific influence of the board of directors’ financial expertise of independent committee

members (see Table 4 Column II).

With respect to individual components of board of director effectiveness, the coefficients on

Ind_BoDjt, Expt_BoDjt and Exp_BoDjt are positive (Table 4 Column I, II and III). The coefficient on

Expt_BoDjt is the only one significant (Table 4 Column II; p<0.05). The coefficient on Dil_BoDjt,

meanwhile, is negative but insignificant from zero (see Table 4 Column IV). The findings suggest

those boards composed of independent directors with financial qualifications and prior experience is

associated with higher earnings. The number of meetings held by the board of directors, however, is

not associated with earnings.

Meanwhile, the coefficients on the two-way Rjt*Ind_BoDjt, Rjt*Expt_BoDjt and Rjt*Dil_BoDjt

interaction variables (see Table 4 Column I, II and IV) are negative but only significant for the first

two variables (p<0.01respectively). The coefficient on the two-way Rjt*Exp_BoDjt interaction variable

is positive but insignificant from zero (see Table 4 Column III). The findings suggest board of

directors that are more independent and had financial qualified independent directors as members were

likely to report negative news quicker than counterparts with less independent, expert and diligent

board of directors. Meanwhile, board of directors with more experienced independent members and

met more frequently are likely to recognize negative news just as readily as board of directors without

independent members with prior experience and that met less frequently.

Finally, in respect to the key three-way interaction variables (i.e., Rjt* DRjt*Ind_BoDjt, Rjt*

DRjt*Expt_BoDjt, Rjt* DRjt*Exp_BoDjt and Rjt* DRjt*Dil_BoDjt) results tabulated in Table 4 are similar

to the associated two-way interaction variables. Specifically, the coefficients of each three-way

interaction variable are positive. Meanwhile, the coefficients on Rjt* DRjt*Ind_BoDjt and Rjt*

DRjt*Expt_BoDjt are significant (see Table 4 Column I and II; p<0.01 respectively). The three-way

interaction results imply an earnings are more conservative amongst firms with board of directors that

are of greater independence and composed of independent directors with financial expertise.

4.3 Robustness Tests

Prior research highlights a number of contentious issue regarding tests of accounting conservatism that

could influence empirical findings. For example, there is lengthy debate in the extant literature about

difficulties in measuring market-adjusted returns. Many studies commonly use a single market-index.

However, researchers (e.g., Ahmad-Zaluki et al., 2007) argue listed firms that constitute the whole

market represent a variety of characteristics that cannot be easily captured by a narrower index. For

instance, many major market indices (e.g., Dow Jones Index, FTSE 100, DAX Index, SMI Index)

often only include well known large entities. Consequently, this may introduce size biases in the

17 | P a g e

calculation of market-adjusted returns. Following Ahmad-Zaluki et al., (2007), market-adjusted

returns are recalculated using three alternative indices in an effort to better control for biases such as

size and industry. First, market-adjusted returns are calculated using the ASX 200 Index. This is a

narrow index than the All Ordinaries Index. Second, to better control for size market-adjusted returns

for firms included in the: (a) 1st Quartile are based on the All Ordinaries Index; (b) 2nd Quartile are

based on the ASX 200 Index; (c) 3rd Quartile are based on the Mid-Cap 50 Index; and (d) 4th Quartile

based on the Small Ordinaries Index. Finally, with consideration for industry differences market-

adjusted returns calculated using an industry index relevant to the major industry sector of each firm.

Tests performed using alternative market-adjusted return calculations are reported in Table 5.

[Insert Table 5 About Here]

Table 5 results related to variables of primary interest to this study (i.e., Rjt*BoDjt and Rjt*

DRjt*BoDjt) are consistent with Table 3 results. Specifically, the coefficients on Rjt*BoDjt are negative

and significant (p<0.01) in each of the three regressions shown in Table 5. Meanwhile, the coefficients

Rjt* DRjt*BoDjt are positive and significant (p<0.01). Table 5 results imply that regardless of the index

used to measure the market-adjusted returns, more effective board of directors appear to recognize

negative news more swiftly than less effective board of directors, and also report more conservative

earnings numbers.

Whilst Table 5 results related to the main variables of interest are consistent with Table 3

results, it is important to note differences do arise in respect to other variables. For example, the

coefficient on DRjt is positive across the three regressions reported in Table 5. However, when market-

adjusted returns are controlled for size or industry biases the coefficients are not significant.

5. Conclusions

This study analyses the association between earnings conservatism and board of director

effectiveness. Accounting conservatism is reputed to produce earnings that reflect negative news faster

than good news. Earnings conservatism has been conceptualized in different manners such as

timeliness and persistence. This study focuses on the timeliness of earnings news using Basu’s (1997)

model. Board of director effectiveness is considered to be the composite outcome of interrelated

characteristics. Specifically, board of director effectiveness in this study is constructed based on the

concepts of independence, financial expertise, prior experience and diligence.

The study collected data from a sample of 100 Australian publicly listed firms stratified-

randomly selected based on market capitalization to reduce size-biases. Data is collected for the 2008

financial year. Consistent with expectations (see GH), empirical results indicate more effective board

of directors a more likely to incorporate negative news into earnings significantly faster (i.e., more

timely) than less effective board of directors. This implies firms with more effective board of directors

are more likely to report more reliable accounting information than firms with less effective board of

directors. Additional analysis also shows that board of directors that are more independent, have

18 | P a g e

independent members who are financially qualified and meet more frequently were more likely to be

associated with disclosure of negative news in a more timely manner. This finding is consistent with

expectations presented in H1, H2 and H4. However, results show board of directors composed of at

least one independent director with prior committee experience were just as likely to report negative

news in a similar time frame as board of directors without such experienced members. This finding is

contrary to expectations (see H3).

Our findings are consistent with evidence reported by others such as Ahmed and Duellmann

(2007), Beekes et al., (2004), Lara et al., (2007, 2009) and Lobo and Zhou (2006) investigating the

link between corporate governance and earnings conservatism. Findings of this study are of merit as it

focuses on a key component of corporate governance that has come under intense scrutiny during the

past decade. Results from this study aid in indicating the importance of corporate governance – and

specifically board of directors – to earnings conservatism and the quality of reported accounting

information. The results provide confidence in the robustness of the respective links by showing the

links present in a jurisdiction where the demand for less conservative accounting numbers may be less

due to reduced litigation risk.

While this study provides interesting results, it is acknowledged that findings are preliminary.

This study is part of a larger and broader analysis during which a more comprehensive data set

spanning a longer time period will be collected. Future research using the additional data will add in

supporting or refuting of evidence presented in this paper. Despite any limitations this paper does

provide grounds for additional research.

19 | P a g e

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Table 1: Sample selection and industry breakdown

Panel A: Sample selectionNumber of firms listed on the ASX as at January 1, 2008 2121Exclusions:

Financial Institutions 31Insurance 22Utilities 9IPO Firms 81Foreign incorporated firms 236Firms not continuously listed 43Missing data 71

Sample pool for random selection 1628Number randomly selected 100Excluded due to missing data 6

Final useable sample 94Panel B: Sample firm breakdown by industryASX Industry No. of Firms % of Sample

Consumer Discretionary 13 13.829Consumer Staples 4 4.256Energy 6 6.384Health Care 13 13.829Industrials 26 27.659Information Technology 7 7.447Materials 23 24.469Telecommunication Services 2 2.127

Total 94 100

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Table 2: Descriptive statistics

Variable Statistic Pooled-Sample

1st Quartile 2nd Quartile 3rd Quartile 4th Quartile

(n=94) (n=24) (n=24) (n=22) (n=24)

OPATjt ($’000) Mean(Median)

19,873(211)

74,775(68,074)

6,682(3,025)

-1,676(-1,646)

-2,084(-1,123)

OPATjt-1 ($’000) Mean(Median)

52,682(344)

208,289(92,069)

909(2,106)

-2,321(-1,386)

-732(-859)

XjtMean

(Median)-0.032(0.003)

0.012(0.053)

0.035(0.023)

-0.016(-0.035)

-0.160(-0.120)

MarCapjt ($’000) Mean(Median)

1,044,853(47,557)

3,891,918(1,435,846)

160,746(111,269)

32,814(25,435)

9,597(6,977)

MarCapjt-1 ($’000) Mean(Median)

1,260,557(65,716)

4,706,131(2,389,310)

183,902(152,931)

39,443(35,973)

10,991(10,641)

RjtMean

(Median)-0.073

(-0.107)0.070

(0.012)-0.064

(-0.086)-0.136

(-0.107)-0.169

(-0.216)

DRjtCount

(%Sample)57

(60.638)11

(45.833)14

(58.333)14

(63.636)18

(75.000)

Size_BoDjt Mean

(Median)5.470

(5.000)7.960

(7.500)5.710

(5.000)4.140

(4.000)3.960

(3.500)

%Ind_BoDjt Mean

(Median)47.763

(50.000)65.483

(71.429)46.690

(50.000)46.364

(36.667)32.401

(33.333)

Ind_BoDjtCount

(%Sample)50

(53.191)18

(75.000)14

(58.333)10

(45.455)8

(33.333)

%Expt_Acc_BoDjt Mean

(Median)24.439

(22.500)26.271

(26.136)25.372

(20.000)23.258

(22.500)22.758

(20.000)

Expt_Acc_BoDjtCount

(%Sample)69

(73.404)22

(91.667)19

(79.167)15

(68.182)13

(54.167)

%Expt_CEONP_BoDjt Mean

(Median)8.049

(0.000)8.089

(0.000)9.716

(0.000)9.242

(0.000)5.248

(0.000)

Expt_CEONP_BoDjtCount

(%Sample)32

(34.043)10

(41.667)9

(37.500)8

(36.363)5

(20.833)

Expt_BoDjtCount

(%Sample)75

(79.787)22

(91.667)20

(83.333)18

(75.000)15

(62.500)

%AC_Exp_BoDjt Mean

(Median)41.943

(40.000)53.465

(56.349)41.071

(37.500)50.000

(50.000)23.909

(16.667)

Exp_BoDjtCount

(%Sample)77

(81.915)23

(95.833)20

(83.333)22

(100.0)12

(50.000)

#Act_Meetg_BoDjtMean

(Median)10.710

(10)11.380

(10.000)12.170

(11.500)9.320

(9.500)9.880

(8.500)

Dil_BoDjtCount

(%Sample)54

(57.447)14

(58.333)18

(75.000)11

(50.000)11

(45.833)

BoDjtMean

(Median)2.330

(3.000)3.708

(4.000)2.667

(3.000)1.818

(2.000)1.083

(1.000)Legend:OPATjt ($’000) = Operating profit after tax and interest of firm j for time period t expressed in AUD$’000; OPATjt-1 ($’000) = Operating profit after tax and interest of firm j for time period t-1 expressed in AUD$’000; Xjt = Operating profit after tax of firm j deflated by market value of equity (MVE t-1 - Market value of equity of firm j at beginning of the fiscal year t) of firm j at beginning of the fiscal year t; MarCapjt ($’000) = Market capitalization of firm j for time period t expressed in AUD$’000;MarCapjt-1 ($’000) = Market capitalization of firm j for time period t-1 expressed in AUD$’000; Rjt = Buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1

is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the All Ordinaries Index between dates relevant to the buy-and-hold return period of firm j; DRjt = Indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0); Size_BoDjt = Number of individuals on the audit committee of firm j at the end of time period t; %Ind_BoDjt = Percentage of members of the audit committee of firm j at the end of time period t designated as independent directors; Ind_All_BoDjt = Indicator variable that takes the value of 1 if all members of the audit committee of firm j in time period t are independent directors, and 0 otherwise; Ind_BoDjt = Indicator variable that takes the value of 1 if the majority of the audit committee of firm j in time period t are independent directors, and 0 otherwise; %Expt_Acc_BoDjt = Percentage of the independent directors of the audit committee of firm j at the end of time period t having necessary accounting educational and/or professional affiliations to be defined as a financial expert; Expt_Acc_BoDjt = Indicator

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variable where firm j is scored 1 if at least one independent director of the audit committee of firm j at the end of time period t has necessary accounting educational and/or professional affiliations to be defined as a financial expert; %Expt_NPCEO_BoDjt = Percentage of the independent directors of the audit committee of firm j at the end of time period t having non-for-profit chief executive officer experience to be defined as a financial expert; Expt_NPCEO_BoDjt = Indicator variable where firm j is scored 1 if at least one independent director of the audit committee of firm j at the end of time period t has necessary non-for-profit chief executive officer experience to be defined as a financial expert; Expt_BoDjt = Indicator variable that takes the value of 1 if at least one independent director of the audit committee of firm j in time period t has necessary expertise (based on educational, professional affiliations and/or non-for-profit role) to be financially qualified, and 0 otherwise; %AC_Exp_BoDjt = Percentage of the independent directors of the audit committee of firm j at the end of time period t having prior audit committee experience with another listed firm; Exp_BoDjt = Indicator variable that takes the value of 1 if at least one independent director of the audit committee of firm j in time period t has prior audit committee experience, and 0 otherwise; Dig_BoDjt = Indicator variable that takes the value of 1 if the audit committee of firm j in time period t met ten [10] or more times during time period t, and 0 otherwise; and BoDjt = Composite audit committee effectiveness score of firm j in fiscal year t.

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Table 3: Multiple regression analysis of audit committee effectiveness and earnings conservatism

Column I: Univariate Model Column II: Base Model Column III: Full ModelVariables Beta t-Stat P-value Beta t-Stat P-value Beta t-Stat P-valueIntercept -0.013 -0.463 0.645 0.030 0.561 0.576 -0.441 -2.182 0.032**DRjt 0.432 2.362 0.027** 0.427 1.767 0.081***BoDjt 0.149 2.372 0.020**DRjt*BoDjt -0.145 -1.829 0.071***Rjt 0.262 4.102 0.000* 0.183 1.848 0.068 1.858 4.808 0.000*Rjt*DRjt 1.158 2.756 0.007** -1.481 -2.804 0.006**Rjt*BoDjt -0.604 -4.536 0.000*Rjt*DRjt*BoDjt 0.589 3.116 0.002**R2 0.155 0.165 0.580Adjusted-R2 0.145 0.137 0.336N 94 94 94F-Statistic 16.828* 7.575* 6.230*

Legend: Column I Equation: Xjt = α0 + β0Rjt + εjt

Column II Equation: Xjt = α0 + α1DRjt + β0Rjt + β1Rjt*DRjt + εjt

Column III Equation: Xjt = α0 + α1DRjt + α2BoDjt + α3DRjt*BoDjt + β0Rjt + β1Rjt*DRjt + β2Rjt*BoDjt + β3Rjt*DRjt*BoDjt + εjt

Where: Xjt = Operating profit after tax of firm j deflated by market value of equity (MVE t-1 - Market value of equity of firm j at beginning of the fiscal year t) of firm j at beginning of the fiscal year t; DRjt = Indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0); BoDjt = Composite audit committee effectiveness score of firm j in fiscal year t; DRjt*BoDjt = Two-way interaction between indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0), and the composite audit committee effectiveness score of firm j in fiscal year t; Rjt = Buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j; Rjt*DRjt = Two-way interaction between the buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j and indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0); Rjt*BoDjt = Two-way interaction between the buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j and the composite audit committee effectiveness score of firm j in fiscal year t; Rjt*DRjt*BoDjt = Three-way interaction between the buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1

where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j, indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0), and the composite audit committee effectiveness score of firm j in fiscal year t; αk, βk = Coefficients; εjt = Error term; and *, **, *** = significant at the 0.001, 0.05 and 0.10 confidence levels.

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Table 4: Multiple regression analysis of audit committee effectiveness components and earnings conservatism

Column I: BoD Independence Column II: BoD Expertise Column III: BoD Experience Column IV: BoD DiligenceVariables Beta t-Stat P-value Beta t-Stat P-value Beta t-Stat P-value Beta t-Stat P-valueIntercept -0.062 -0.643 0.522 -0.259 -1.819 0.072*** 0.014 0.035 0.972 0.051 0.579 0.564DRjt 0.018 0.141 0.888 0.348 1.876 0.064*** 0.035 0.087 0.931 0.012 0.090 0.928Ind_BoDjt 0.089 0.777 0.439Expt_BoDjt 0.306 2.020 0.046**Exp_BoDjt 0.035 0.090 0.928Dil_BoDjt -0.007 -0.056 0.955DRjt*Ind_BoDjt 0.103 0.577 0.566DRjt*Expt_BoDjt -0.427 -2.080 0.041**DRjt*Exp_BoDjt -0.014 -0.034 0.973DRjt*Dil_BoDjt -0.060 -0.333 0.740Rjt 0.619 3.314 0.001** 1.311 5.191 0.000* -0.268 -0.265 0.792 0.205 1.796 0.076***Rjt*DRjt 0.361 1.259 0.211 0.687 1.560 0.122 0.707 0.658 0.512 0.104 0.351 0.726Rjt*Ind_BoDjt -0.611 -2.813 0.006**Rjt*Expt_BoDjt -1.305 -4.840 0.000*Rjt*Exp_BoDjt 0.461 0.453 0.652Rjt*Dil_BoDjt -0.176 -0.686 0.495Rjt*DRjt*Ind_BoDjt 0.879 2.030 0.045**Rjt*DRjt*Expt_BoDjt 0.941 1.930 0.057***Rjt*DRjt*Exp_BoDjt 0.609 0.554 0.581Rjt*DRjt*Dil_BoDjt 0.261 0.574 0.567R2 0.271 0.368 0.191 0.188Adjusted-R2 0.212 0.317 0.126 0.122N 94 94 94 94F-Statistic 4.576* 7.158* 2.908* 2.849*

Legend: Column I Equation: Xjt = α0 + α1DRjt + α2Ind_BoDjt + α3DRjt*Ind_BoDjt + β0Rjt + β1Rjt*DRjt + β2Rjt*Ind_BoDjt + β3Rjt*DRjt*Ind_BoDjt + εjt

Column II Equation: Xjt = α0 + α1DRjt + α2Expt_BoDjt + α3DRjt*Expt_BoDjt + β0Rjt + β1Rjt*DRjt + β2Rjt*Expt_BoDjt + β3Rjt*DRjt*Expt_BoDjt + εjt

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Column III Equation: Xjt = α0 + α1DRjt + α2Exp_BoDjt + α3DRjt*Exp_BoDjt + β0Rjt + β1Rjt*DRjt + β2Rjt*Exp_BoDjt + β3Rjt*DRjt*Exp_BoDjt + εjt

Column IV Equation: Xjt = α0 + α1DRjt + α2Dil_BoDjt + α3DRjt*Dil_BoDjt + β0Rjt + β1Rjt*DRjt + β2Rjt*Dil_BoDjt + β3Rjt*DRjt*Dil_BoDjt + εjt

Where: Xjt = Operating profit after tax of firm j deflated by market value of equity (MVE t-1 - Market value of equity of firm j at beginning of the fiscal year t) of firm j at beginning of the fiscal year t; DRjt = Indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0); Ind_BoDjt = Indicator variable that takes the value of 1 if the majority of the audit committee of firm j in time period t are independent directors, and 0 otherwise; Expt_BoDjt = Indicator variable that takes the value of 1 if at least one independent director of the audit committee of firm j in time period t has necessary expertise (based on educational, professional affiliations and/or non-for-profit role) to be financially qualified, and 0 otherwise; Exp_BoDjt = Indicator variable that takes the value of 1 if at least one independent director of the audit committee of firm j in time period t has prior audit committee experience, and 0 otherwise; Dig_BoDjt = Indicator variable that takes the value of 1 if the audit committee of firm j in time period t met ten [10] or more times during time period t, and 0 otherwise; DRjt*X_BoDjt - Two-way interaction between indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0), and each applicable individual component of audit committee effectiveness where X_BoDjt is: (a) Ind_BoDjt in Column I; (b) Expt_BoDjt in Column I; (c) Exp_BoDjt in Column III; and (d) Dil_BoDjt in Column IV; Rjt = Buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j; Rjt*DRjt = Two-way interaction between the buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j and indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0); Rjt* X_BoDjt - Two-way interaction between the buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j and each applicable individual component of audit committee effectiveness where X_BoDjt is: (a) Ind_BoDjt in Column I; (b) Expt_BoDjt in Column I; (c) Exp_BoDjt in Column III; and (d) Dil_BoDjt in Column IV; Rjt*DRjt*X_BoDjt = Three-way interaction between the buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j, indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0), and each applicable individual component of audit committee effectiveness where X_BoDjt is: (a) Ind_BoDjt in Column I; (b) Expt_BoDjt in Column I; (c) Exp_BoDjt in Column III; and (d) Dil_BoDjt in Column IV; αk, βk = Coefficients; εjt = Error term; and *, **, *** = significant at the 0.001, 0.05 and 0.10 confidence levels.

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Table 5: Multiple regression analysis alternative market index

Column I: ASX 200 Index† Column II: Size adjusted indexΨ Column III: Industry specific index¥

Variables Beta t-Stat P-value Beta t-Stat P-value Beta t-Stat P-valueIntercept -0.444 -2.200 0.030** -0.298 -1.768 0.081*** -0.388 -2.191 0.031**DRjt 0.425 1.769 0.080*** 0.247 1.102 0.273 0.329 1.464 0.147BoDjt 0.151 2.395 0.019** 0.103 1.932 0.057*** 0.148 2.607 0.011**DRjt*BoDjt -0.144 -1.824 0.072*** -0.096 -1.274 0.206 -0.139 -1.881 0.063***Rjt 1.864 4.840 0.000* 1.441 4.362 0.000* 1.596 4.935 0.000*Rjt*DRjt 1.496 2.842 0.006** 1.124 2.081 0.040** 1.439 3.348 0.001**Rjt*BoDjt -0.606 -4.567 0.000* -0.465 -3.986 0.000* -0.523 -4.549 0.000*Rjt*DRjt*BoDjt 0.597 3.171 0.002** 0.442 2.269 0.026** 0.549 3.462 0.001**R2 0.583 0.534 0.597Adjusted-R2 0.339 0.286 0.357N 94 94 94F-Statistic 6.310* 4.913* 6.818*

Legend: † - Market-adjusted returns are calculated using the ASX 200 Index;Ψ – Market-adjusted returns for firms included in the: (a) 1 st Quartile are based on the All Ordinaries Index; (b) 2nd Quartile are based on the ASX 200 Index; (c) 3rd Quartile are based on the Mid-Cap 50 Index; and (d) 4th Quartile based on the Small Ordinaries Index;¥ - Market-adjusted returns are based on the industry index relevant to the major industry sector each firm is classified under;Column I, II and III Equation:Xjt = α0 + α1DRjt + α2BoDjt + α3DRjt*BoDjt + β0Rjt + β1Rjt*DRjt + β2Rjt*BoDjt + β3Rjt*DRjt*BoDjt + εjt

Where: Xjt = Operating profit after tax of firm j deflated by market value of equity (MVE t-1 - Market value of equity of firm j at beginning of the fiscal year t) of firm j at beginning of the fiscal year t; DRjt = Indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0); BoDjt = Composite audit committee effectiveness score of firm j in fiscal year t; DRjt*BoDjt = Two-way interaction between indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0), and the composite audit committee effectiveness score of firm j in fiscal year t; Rjt = Buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j; Rjt*DRjt = Two-way interaction between the buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j and indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0); Rjt*BoDjt = Two-way interaction between the buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1 where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j and the composite audit committee effectiveness score of firm j in fiscal year t; Rjt*DRjt*BoDjt = Three-way interaction between the buy-and-hold return over the fiscal year t of firm j (i.e., (Pt – Pt-1)/Pt-1

where Pt is the price of shares for firm j at the end of the fiscal year t and Pt-1 is the price of shares for firm j at the start of the fiscal year t) adjusted for the change in the market index between dates relevant to the buy-and-hold return period of firm j, indicator variable where firm j is scored one (1) if Rjt is negative, otherwise firm j is scored zero (0), and the composite audit committee effectiveness score of firm j in fiscal year t; αk, βk = Coefficients; εjt = Error term; and *, **, *** = significant at the 0.001, 0.05 and 0.10 confidence levels.

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