Board Independence and Real Earnings Management: The Case of R&D Expenditure

This paper analyses the role of boards of directors in constraining research and development (R&D) spending manipulation. Extant research on earnings management indicates that independent directors reduce accounting accruals manipulation. However, there is limited evidence on their effectiveness in limiting potentially value reducing R&D cuts motivated by short-term earnings pressures. Using a large sample of UK firms, I study whether independent boards are efficient at detecting and constraining this type of real earnings management. The results indicate that independent directors have sufficient technical knowledge to identify opportunistic reductions in R&D, and efficiently constrain opportunistic R&D spending. This evidence supports the emphasis recent policy statements have put on increasing the number of independent directors on corporate boards.

[1]  P. Pope,et al.  Accrual management to meet earnings targets: UK evidence pre- and post-Cadbury , 2000 .

[2]  James R. Booth,et al.  Factors affecting the number of outside directorships held by CEOs , 1996 .

[3]  P. Pope,et al.  Earnings management and the distribution of earnings relative to targets: UK evidence , 2007 .

[4]  Mary E. Barth,et al.  Market rewards associated with patterns of increasing earnings , 1999 .

[5]  Peter Easton,et al.  Earnings Management? The Shapes of the Frequency Distributions of Earnings Metrics are Not Evidence Ipso Facto , 2005 .

[6]  E. Fama,et al.  Risk, Return, and Equilibrium: Empirical Tests , 1973, Journal of Political Economy.

[7]  Shivaram Rajgopal,et al.  The Economic Implications of Corporate Financial Reporting , 2005 .

[8]  Empirical Studies of Innovation in the Knowledge Driven Economy , 2006 .

[9]  Michael D. Shields,et al.  An empirical analysis of the expenditure budget in research and development , 1988 .

[10]  René M. Stulz,et al.  The Determinants and Implications of Corporate Cash Holdings , 1997 .

[11]  April Klein,et al.  Audit Committee, Board of Director Characteristics, and Earnings Management , 2002 .

[12]  Eli Bartov,et al.  The Timing of Asset Sales and Earnings Manipulations , 1993 .

[13]  M. W. Nelson,et al.  Evidence from Auditors About Managers' and Auditors' Earnings-Management Decisions , 2001 .

[14]  Paul Zarowin,et al.  Capitalization of R&D and the Informativeness of Stock Prices , 2007 .

[15]  John W. Byrd,et al.  Do outside directors monitor managers , 1992 .

[16]  Jonathan L. Johnson,et al.  Boards of Directors: A Review and Research Agenda: , 1996 .

[17]  A. Shleifer,et al.  A Survey of Corporate Governance , 1996 .

[18]  D. Collison,et al.  Evidence of Managerial Short‐termism in the UK , 1998 .

[19]  Daniel Ferreira,et al.  A Theory of Friendly Boards , 2007 .

[20]  M. McNichols,et al.  Does Meeting Expectations Matter? Evidence from Analyst Forecast Revisions and Share Prices , 1999 .

[21]  Baruch Lev,et al.  Information Asymmetry, R&D, and Insider Gains , 2000 .

[22]  J. Zimmerman.  Accounting for Decision Making and Control , 1994 .

[23]  Ilia D. Dichev,et al.  Earnings Management to Avoid Earnings Decreases and Losses , 1997 .

[24]  Thomas A. Turk,et al.  Effects of Board and Ownership Structure on Corporate R&D Strategy , 1991 .

[25]  P. Allison.  Fixed Effects Regression Methods for Longitudinal Data Using SAS® , 2005 .

[26]  M. Useem,et al.  Oversight and Delegation in Corporate Governance: Deciding What the Board Should Decide , 2006 .

[27]  Shijun Cheng.  R&D Expenditures and CEO Compensation , 2004 .

[28]  Christine I Wiedman.  The Relevance of Characteristics of the Information Environment in the Selection of a Proxy for the Market's Expectations for Earnings -- An Extension of Brown, Richardson and Schwager [1987] , 1996 .

[29]  R. Walker,et al.  Reporting on Software Development Projects to Senior Managers and the Board , 2006 .

[30]  Patricia M. Dechow,et al.  Causes and Consequences of Earnings Manipulation: An Analysis of Firms Subject to Enforcement Actions by the SEC* , 1996 .

[31]  Patricia M. Dechow,et al.  DETECTING EARNINGS MANAGEMENT , 1994 .

[32]  Myles L. Mace,et al.  Directors: Myth and Reality , 1971 .

[33]  J. Galán,et al.  Influence of industry R&D intensity on corporate product diversification: interaction effect of free cash flow , 2006 .

[34]  G. Whittington.  Corporate Governance and the Regulation of Financial Reporting , 1993 .

[35]  Parthiban David,et al.  The Influence of Activism by Institutional Investors on R&D , 2001 .

[36]  H. G. Hunt,et al.  An empirical examination of debt covenant restrictions and accounting-related debt proxies , 1990 .

[37]  Edwin Mansfield,et al.  Social and Private Rates of Return from Industrial Innovations , 1977 .

[38]  Steven Young,et al.  The Link between Earnings Timeliness, Earnings Conservatism and Board Composition: Evidence from the UK , 2004 .

[39]  I. Demirag,et al.  Boards of Directors' short-term perceptions and evidence of managerial short-termism in the UK , 1998 .

[40]  Brian J. Bushee.  The Influence of Institutional Investors on Myopic R&D Investment Behavior , 1999 .

[41]  P. Pope,et al.  Board Monitoring and Earnings Management: Do Outside Directors Influence Abnormal Accruals? , 2000 .

[42]  Laura Cabeza García,et al.  Governance and Performance of Spanish Privatised Firms , 2007 .

[43]  Beatriz García Osma,et al.  The Effect of the Board Composition and its Monitoring Committees on Earnings Management: Evidence from Spain , 2007 .

[44]  S. Young.  Systematic Measurement Error in the Estimation of Discretionary Accruals: An Evaluation of Alternative Modelling Procedures , 1999 .

[45]  Philip G. Berger.  EXPLICIT AND IMPLICIT TAX EFFECTS OF THE RESEARCH-AND-DEVELOPMENT TAX CREDIT , 1993 .

[46]  Sanjai Bhagat,et al.  The Uncertain Relationship between Board Composition and Firm Performance , 1997 .

[47]  Mary E. Barth,et al.  Analyst Coverage and Intangible Assets , 2000 .

[48]  Anwer S. Ahmed,et al.  Bank Loan Loss Provisions: A Reexamination of Capital Management, Earnings Management and Signaling Effects , 1998 .

[49]  Scott A. Snell,et al.  External control, corporate strategy, and firm performance in research‐intensive industries , 1988 .

[50]  E. Fama,et al.  Separation of Ownership and Control , 1983, The Journal of Law and Economics.

[51]  Araceli Mora,et al.  Discussion of the Effect of Earnings Management on the Asymmetric Timeliness of Earnings , 2005 .

[52]  I. Demirag.  ASSESSING SHORT-TERM PERCEPTIONS OF GROUP FINANCE DIRECTORS OF UK COMPANIES , 1995 .

[53]  Daniel M. Kammen,et al.  Evidence of under-investment in energy R&D in the United States and the impact of Federal policy , 1999 .

[54]  Dan Givoly,et al.  The Rewards to Meeting or Beating Earnings Expectations , 1999 .

[55]  Theodore Sougiannis.  The Accounting Based Valuation of Corporate R&D , 1994 .

[56]  M. Weisbach.  Outside directors and CEO turnover , 1988 .

[57]  Y. T. Mak,et al.  The relationship between managerial ownership and firm performance in high R&D firms , 2002 .

[58]  J. Heckman.  Sample selection bias as a specification error , 1979 .

[59]  I. Demirag.  An empirical study of research and development top managers' perceptions of short-term pressures from capital markets in the United Kingdom , 1995 .

[60]  W. D. Bondt,et al.  R&D budgets and corporate earnings targets , 1998 .